Collateral Value

Collateral value is the worth of an asset used as collateral in a borrowing transaction. The collateral could be stocks, bonds, real estate, or even collections. The value of the asset determines the loan amount that can be sanctioned to a borrower. 

The primary reason for collateral involvement in a lending transaction is that it enhances the lender's confidence in credit extension. Organizations look at it as a tool for risk mitigation and help companies comply with rules. Additionally, the value determines loan terms and interest rates based on risk exposure.

Collateral value is the estimated worth of an asset pledged by a borrower to secure a loan. The value determines the loan sanctioned. Generally speaking, the loan sanctioned will be more significant when the value of the collateral is higher. Similarly, the lesser the value of the collateral, the smaller the loan amount. Collaterals can be of varied types. They include tangible assets, intellectual properties, accounts receivables, stocks, bonds, and other assets. 

The value of collateral is influenced by various factors, including market conditions, the asset's quality, liquidity, and associated risks. Similarly, legal considerations, industry-specific factors, and geographical factors all play a role in determining the value of collateral. 

There are different methods for assessing the value of collateral. They are the market value approach, the discounted cash flow method, the loan-to-value ratio, the liquidation value, the comparable approach, and the intangible collateral assessment.

The value of the collateral is estimated to understand the risk incurred by the lender when offering a loan. If the collateral's value is higher, it also helps the borrower get better loan terms and lower interest rates. This is because even if the borrower defaults on the payments, the lender can recover the loss by selling the collateral.

The value of a collateral can be assessed using the following methods. 

• Appraisal based valuation - Lenders evaluate assets based on their condition, market value, and potential future cash flows. 
• Discounted cash flow methods - The method discounts future cash flows that an asset is capable of generating with its present value. The discount rate reflects the risks involved.   
• Loan to value ratio - Lenders peg the loan amount to the appraised value of collateral on a percentage basis. It is used to measure the level of risk involved.   
• Market liquidity assessment - The collaterals are segregated based on their liquidity. Bonds, for example, are highly liquid and can be sold quickly, which makes them hold high value.

Let us look into some of the examples to understand the concept better: 

Example #1

Imagine Dan is an investor who wants to acquire a residential property and uses a collateral value calculator.   

Dan first assesses the market value and inputs it into the collateral value calculator. He then proceeded to input the rest of the details the calculator asked for. He then realizes that the collateral value of real estate was much better than expected as the amenities in its locality are good and hence attract buyers.

Furthermore, he calculates the loan-to-value ratio to see if it is possible to secure a loan. The following formula can be used:

Loan amount availed / collateral asset's value x 100 

Suppose the loan amount is 100000 and the collateral value is 200000. By applying the formula, we get,

Loan to value (LTV) ratio = 100000/200000*100=50%. 

Typically, lenders prefer a ratio that does not exceed 80%, and since his LTV ratio is 50%, the lenders will face less risk. This means easier sanctioning of the loan. 

Example #2

The DTC, or the depository trust company, has stated that there are significant changes in collateral valuations. It revealed that an increased haircut will accompany bonds or corporate notes rated B1-B3. Similarly, it revealed that no value would be given to ETFs (exchange-traded funds) and crypto-based investment vehicles. The securities issued by affiliates of specified lenders will have a 100 % haircut.

Some of the points that highlight the importance of estimating the value of collaterals are given below: 

• It helps in the risk assessment of the loan for the lenders 
• It offers protection against money loss in case of default 
• It impacts the loan amount sanctioned
• It influences the loan terms and conditions put forth by the lender.
• It reduces the interest rates of the loan if the valuation is high.
• It helps organizations comply with banking regulations
• It helps the lenders manage their risks and liquidity.
• It is a reflection of the market rates. This can provide insights into how the market is performing.

Given below are the differences between both values: 

• Collateral value is the value that a lender assigns to a pledged asset for the provision of a loan. The value is calculated for all items pledged. Market value is an asset that reflects its current market value. It is the rate at which the majority of buyers buy.
• The value of collateral is determined by various factors such as location, age, legal constraints, etc. Market value is determined by a buyer's willingness to pay the seller when they are both well-informed and there is no pressure to trade. 
• The value of collateral is determined to check if the loan is worth giving. It is typically lower than market value. If there is a big difference between the value of collateral and market value, the risk increases, and vice versa. Market value is used to see the appreciation of an asset at present and in the future.