Advance Rate
The maximum amount of money a lender is willing to extend to a borrower based on the percentage of the collateral’s value
What Is An Advance Rate?
An advance rate is the maximum amount of money a lender is willing to extend to a borrower based on the percentage of the collateral's value. Collateral is an asset of the borrower, and its value is determined by the lender based on its current market value.
The lender assesses the borrower's financial conditions to ensure the borrower's ability to repay the loan received by the lender.
After the lender finishes assessing the borrower's financial status, he/her will notify the borrower of the maximum amount that can be borrowed and their current advance rate.
Lenders typically offer this rate to be assured that the risk they are taking to help make the loan possible and that their exposure to any loss is minimal, knowing that the collateral's value could fluctuate over time.
While a collateral's current market value plays a significant role in determining the advance rate lenders are willing to extend to a borrower, it is not the only factor that comes into play.
It is also essential for the lender to look up any relevant financial information about the borrower. For example, this information could include the borrower's credit rating and the level of income they generate to determine the borrower's creditworthiness.
The purpose of this rate is to minimize the lender's exposure to any potential drop in the collateral's value. For example, if the value of the collateral drops and the loan goes into default, the principal loss of the loan would still provide protection.
Key Takeaways
- An advance rate represents the maximum loan amount a lender is willing to provide to a borrower, determined as a percentage of the collateral's current market value.
- Lenders assess the borrower's financial condition to ensure repayment ability. The advance rate is a tool used by lenders to manage risk, considering factors such as collateral value, borrower's credit rating, and income.
- An increase in the advance rate elevates the lender's risk, making it crucial for lenders to balance risk and return. Higher advance rates result in higher required interest rates on loans, compensating for the increased risk.
- While similar to the loan-to-value ratio, the advance rate is associated with the overall facility, indicating what percentage of loans/collateral can be acquired through a line of credit.
Understanding an Advance Rate
It indicates the maximum loan value a lender is comfortable extending to the borrower based on the collateral's value.
Once that rate increases, the lender, in the event of a loan default, faces a greater risk of not being able to reclaim loan losses by liquidating the collateral. This means the higher the rate proposed, the higher the risk issued to the lender.
One might ask, 'why would lenders want to increase the rate when they could just play it safe and lower the loan loss cushion with a lower rate?'
A higher rate leads to a higher required interest rate on loan for the borrower. This indicates the lender's risk tolerance after assessing the borrower's financial condition to be assured if it's worth taking the risk to get a higher required interest rate on the borrower.
To put it simply:
As the rate increases, loan losses cannot be recovered by liquidating the collateral.
As that risk increases, the required interest rate on loan for the borrower increases, meaning there is compensation for the risk the lender takes.
It is also similar to the loan-to-value (LTV) ratio, another lending risk assessment ratio.
The difference is that LTV is more related to individual loans and how much they pay, whereas the advance rate is more associated with the overall facility.
A 60% rate means 60% of loans/collateral can be purchased using that line of credit, and the other 40% is provided by subordinated debt or equity.
Formula & Example of Advance Rate
The formula is known as:
Advance Rate (%) = Maximum Loan Value / Collateral Value x 100
A few examples to illustrate its use:
Example 1: Jane uses her collateral valued at 200$ to borrow a loan amount of 130$. We use the formula to find out the rate the lender issued to the borrower.
Advance rate = 130/200 x 100 = 65%
Example 2: If you borrow a maximum loan amount of 80$ at an advance rate of 75% from me, how much was the collateral's value offered to me? To get this, we derive the formula above.
Collateral value = Maximum Loan Value/Advance Rate x 100
Collateral value = 80$/75% x 100
Collateral Value = 106.67$
Example 3: Suppose Mike has collateral valued at 150$ and borrowed 180$ at an advance rate of 120%. In the case of a default on loan, how much money would the lender receive/lose, assuming the collateral's value stays the same at 150$?
In the case of a default, the lender would lose 30$ with the collateral selling at 150$, 30$ less than 180$. For example, if the collateral's value were to increase by the time of default to 170$, the lender would lose just 10$.
Advantages and Disadvantages of Advance Rate
Lenders use these rates to protect against any losses. For example, suppose the borrower were to offer collateral at the current market value of 200$. In that case, the lender should issue a rate of, let's say, 70% (based on the borrower's financial condition) rather than thoroughly loan the 200$.
Researched and authored by Jad Shamseddine | LinkedIn
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