The collateral coverage ratio represents the percentage of a loan secured by a discounted asset and is used by lenders to set maximum loan limits. For example, mortgage lenders typically value property at a discounted rate of 80% of fair market value (FMV) and offer loans with a minimum collateral coverage ratio of one, or an 80% loan-to-value (LTV).
Collateral Coverage Ratio Formula
Calculating the collateral coverage ratio is relatively simple. We will show you the formula and include examples of how to calculate each component.
The collateral coverage ratio formula is:
Collateral Coverage Ratio = (Discounted Collateral Value) / (Total Loan Amount)
Collateral Coverage Ratio Example
Now that you know the formula, let’s discuss each component of the collateral coverage ratio in detail. This will help you calculate your discounted collateral value, total loan amount, as well as your overall collateral coverage ratio.
Discounted Collateral Value
Collateral value is the estimated fair market value (FMV) or appraised value of an asset used to secure a loan. However, when lender’s set maximum loan limits, they will typically discount the collateral secured by a loan. This builds in the potential for a decline in value through normal use and cost of collection & sale in case of default.
For this reason, lenders typically require that a loan can’t be more than the discounted value of the underlying collateral. This is why real estate might have a discounted collateral value of 80% while furniture, fixtures, and equipment (FF&E) might have a discounted collateral value of 30% – 70%. This is because there’s greater risk that the invoice either won’t be collected or will have to be collected at a discount.
For example, if you need $10k in short-term capital, you might be able to take out a working capital loan and collateralize it with either used equipment or office furniture. However, a lender might discount these assets differently, limiting your financing options. If you have $30,000 of used equipment that a lender discounts by 50% and $25,000 of office furniture that a lender discounts by 70%, the discounted collateral values would be:
Used Equipment: ($30,000) x (50%) = $15,000
Office Furniture: ($25,000) x (30%) = $7,500
Total Loan Amount
Total loan amount represents your total current principal loan balance. This doesn’t include interest payments. For example, if you take out a loan for $100,000, your total loan amount is equal to $100,000. If you pay off $10,000 in principal and $2,000 in interest after year one, your total loan amount is $90,000.
Once you know your discounted collateral value and your total loan amount, you can calculate your collateral coverage ratio. Based on the example above, the discounted collateral value of your used equipment is $15,000 and your office furniture is $7,500. The collateral coverage ratio for each asset would be as follows:
Used Equipment: ($15,000) / ($10,000) = 1.5
Office Furniture: ($7,500) x ($10,000) = 0.75
If a lender requires a ratio of at least 1.0, you would therefore have to use your used equipment as collateral for the loan. Otherwise, you’d have to ask for a lower loan amount and use your office furniture as collateral.
Why is the Collateral Coverage Ratio Important?
The collateral coverage ratio is important because it’s used by lenders and creditors to determine maximum loan amounts and minimum required asset collateral. This reduces their risk by ensuring there is enough collateral to cover the loan in case of default. The higher the ratio the less risk for lenders, and vice versa.
For example, most lenders typically prefer a collateral coverage ratio between 1 to 1.6 or higher. Riskier loans will typically have a higher required coverage ratio. Borrowers with low ratios will either need additional guarantees to secure a loan or apply for government-backed loans like SBA loans with lower required ratios.
Pros & Cons of the Collateral Coverage Ratio
In general, a high collateral coverage ratio makes it easier to get approved for a loan. Let’s take a look at the pros of a high coverage ratio as well as the cons of a low ratio.
Pros of a High Collateral Coverage Ratio:
- You have a better chance of getting approved for financing.
- The value of your collateral can pay for your loan in case of financial default.
- You may be able to refinance or use your asset as cross collateral for an additional loan.
- A higher ratio means you have room to request a higher loan amount if needed.
Cons of a Low Collateral Coverage Ratio:
- If your coverage ratio is less than one, you’ll need a cosigner.
- Limits your options to government-backed loans like SBA loans.
Remember, however, that even if you have a high collateral coverage ratio you might still have to sell your entire asset to get the funds necessary to repay a loan in the case of default.
How to Increase Your Collateral Coverage Ratio
Collateral helps your chances of getting approved for a loan since it reduces lender risk in case of default and ensures you have skin in the game. If your collateral coverage ratio is low, however, it might be difficult for you to get financed for the amount you need. The following are ways to increase your collateral coverage ratio:
1. Pledge Higher Value Assets as Collateral
If you need a higher collateral coverage ratio you might need to pledge assets with higher value as collateral. For example, if you’re looking for $30,000 in financing and have a purchase order for $100,000 and outstanding invoices totaling $50,000, the purchase order financing option would have a higher collateral coverage ratio when compared to invoice financing.
2. Pledge Assets with Lower Discount Rates
You can also use an asset’s discount rate to your advantage. For instance, you might have $50,000 in both purchase orders and outstanding invoices. While their overall value is the same, the value of your invoices might be discounted by 50% while the purchase orders might be discounted by only 30% due to less risk. This would increase your coverage ratio.
3. Collateralize Assets Together
Another way to increase your collateral coverage ratio is to collateralize two or more assets together. A general example of this is using both your house and your car as collateral for a single loan. When calculating the collateral coverage ratio, the discounted values of both assets are combined to give you a better chance of getting approved for the loan amount you need.
The collateral coverage ratio is used to calculate the percentage of your loan secured by a discounted asset. Ideally, lenders prefer a ratio equal to 1 or higher to give them a buffer in case of default. A high collateral coverage ratio helps borrowers get approved for loans because it reduces lender risk.