On July 18th the dotCOMM Awards announced that the Lexington Law App won a Gold award. Lexington Law, and other early deadline winners in the 2018 international awards competition, were honored for their excellence in web creativity and digital communication.
Divorce: it is messy, complicated, and so common that it has become part of the cultural norm. Everyone knows someone –– a colleague or a relative, for example –– who has gone through a divorce. However, the frequency of divorce in America does not lessen its effect on the affected parties. It is easy for us to empathize with the emotional toll of divorce. What is perhaps more challenging for us to consider are the financial consequences.
If you are considering applying for a personal or business loan from a bank, the bank may require some sort of collateral as part of the approval process. Collateral is something of value that you own or control that you agree to hand over to the bank if you default on the loan.
If this sounds foreign to you, it is because this type of credit arrangement is not nearly as common as it was many years ago. Since ancient times, if you wanted to borrow money or something else of value, you were expected to leave the lender with something else of value (such as an animal or a costly garment) in expectation of taking the item back when you repay your loan. These days, however, it is far more common for loans to be secured directly by the asset being financed (like a house or vehicle), or by revolving, unsecured credit (like a credit card).
However, collateral is still very much a part of the lending world for those circumstances when the loan you are seeking cannot be directly secured by what you are purchasing. Repayment depends on what happens in the future. A sizeable personal loan for the purpose of debt consolidation, or a business loan to fund expansion are examples of this arrangement.
Understanding how collateral works and what sorts of assets qualify to serve as collateral can help you better decide whether a loan secured in this way is the right choice for you.
How is the value of collateral calculated?
Because collateral serves as risk reduction for the lender, it follows that no lender is going to allow you to borrow every penny that the collateral could possibly be worth. Most lenders will not even consider collateral that is not worth significantly more than the loan principal.
The calculation banks use to determine how much collateral they require is called the loan-to-value (LTV) ratio. In most cases, lenders prefer to lend an amount no more than 70 or 80 percent of the collateral value. For instance, if you have a collection of vintage Star Wars merchandise valued at $100,000, you may be able to use it as collateral to borrow as much as $80,000 in cash. (Note: if your bank’s loan officer is not a Star Wars fan, this option may not work.)
In that respect, this type of collateral works exactly the same as other secured loans, like an auto loan or a mortgage. In that case, the bank is only going to approve a mortgage up to a certain percentage of the value of the property being purchased. They are careful to do so because if you stop paying your mortgage payments and desert the house, the bank wants to ensure they can recover the full value of their loan by selling the house you have left them with.
What assets can be considered as collateral to secure a loan?
The following items are most commonly accepted as collateral for loans that require something beyond the asset being financed. It is important to note, however, that every bank (and every banker) is a little different, and they will all have their own requirements and/or preferences when it comes to what they will accept as collateral.
- Real Property: Land, buildings, vehicles, and land rights that you already own (not that you owe money on) is one of the most effective forms of collateral because it is relatively easy to sell and rarely depreciates significantly in value.
- Valuables: For similar reasons, valuable personal belongings (like art, antiques, gold, or jewelry) can serve as collateral as well. These items can generally be appraised by experts to determine their current and likely future worth with a fair amount of confidence.
- Cash: Perhaps the most popular form of collateral is cash itself, usually in the form of an existing savings account or easily liquidated investment account. While it may seem strange to borrow money if you have adequate cash on hand to serve as collateral, in the case of large investments, the dividends and interest income you lose by withdrawing that much cash can end up costing more than the interest on the loan.
- Future Income: Now we are moving into the realm of potential income, so lenders will view this sort of collateral as far more risky than the items above. However, if you are seeking a business loan and you have a high-quality business plan mapping out exactly what you intend to use the money for (and what the return on investment will be), you can convince a bank to lend you the money based on that alone. Or, they may accept future earnings as a portion of the collateral and require less in the way of real property or cash.
- Inventory and Equipment: For businesses that stock inventory (primarily retailers) and that own specialized equipment (such as manufacturers), these business assets can serve as legitimate collateral for a business loan. They may not be quite as fast to liquidate if the bank needs to seize them, but they are of value and of immediate use to your competition (if no one else).
- Invoices and Accounts Receivable: If your business has a strong history of collecting payment from customers and/or the customers who currently owe you for services rendered have a solid payment history, a lender may accept proof of the money you are owed as collateral. This form of collateral is usually used by businesses to get through a brief, temporary cash crunch so they can cover payroll and operating expenses while waiting for all their money to come in.
- Stocks, Bonds, and Other Investments: Most investments are treated similar to cash as long as the market is strong. Lenders accepting investment portfolios as collateral may even offer as much as 100 percent LTV if they are very confident in the market’s stability. In less certain economic times, however, those same lenders may remove this option from the table completely because of the risk. It is important to note that some investments, including personal retirement accounts and 401k plans, cannot legally be pledged as collateral to secure a loan.
- A Blanket Lien: As the name implies, a blanket lien covers basically all assets under your control, personal or business. Lenders are more likely to jump at this opportunity because it means that if you default on your loan they can go after anything and everything you have to get their money back. Doing so is very dangerous for the consumer. It should only be considered if all other options fail and securing your desired loan is crucial.
For more interesting and valuable financial insight, check out some of these past articles on financial success.
Credit can be complex and confusing. When you’re applying for a loan or credit card, the process can be intimidating — especially when unfamiliar terms start getting thrown around. While some terms are self-explanatory, others can be a bit more ambiguous.
Getting familiar with some of the terms you will encounter in the loan or credit card application process can be beneficial in getting the best loan terms and ensuring you are entering into credit agreements that are favorable for you. Depending on your credit score, of course, you will be eligible for more favorable loan terms and lower interest rates.
Let’s take a look at 11 common credit terms you’re likely to encounter in the process of a credit application scenario.
An interest rate is a percentage of the principal balance your lending institution charges you for borrowing the money. Many factors go into determining a borrower’s interest rate, including credit score, the risk of default and inflation, as well as the length of the loan.
Annual Percentage Rate (APR)
APR is an annual rate that accounts for the interest and other fees paid on a loan or credit card balance. This percentage varies based on the bank or lending institution.
A billing cycle is essentially the number of days between statements on a credit card or loan account. The length of this cycle is typically between 20 and 45 days and is at the discretion of the credit or loan provider. The credit card company or loan institution provides the borrower with a statement once the billing cycle ends. Some lenders will allow the consumer to request a different billing cycle than what is offered.
Minimum amount/payment due
Minimum amount due is the monthly payment a borrower must pay to keep their account current and in good standing, avoiding late fees. The amount of this payment can be fixed or variable based on the outstanding balance on the account. The former is more common on installment loans, and the latter is more common on revolving credit accounts. It’s important to remember, especially with credit cards, that making only the minimum payment won’t yield fast results in paying off a balance, and the longer you carry any balance on a card, the more interest you’ll be paying.
A payoff amount is the total dollar amount that has to be paid to satisfy a debt. Payoff amounts are often more than the principal balance because they include any unpaid interest, late charges or fees. If you are ready to pay off a loan, it’s important to contact the lender to get the correct payoff amount, because interest compounds daily, so that figure is always changing.
Mortgage insurance is completely separate from the insurance borrowers are required to carry on a home in order to secure a loan against it. Mortgage insurance is designed specifically to protect the lender in the event that a borrower defaults on the loan. Mortgage insurance is required in all states for borrowers who have less than a 20-percent equity stake in their home.
Down payments are an initial one-time cash payment that is put towards a loan at the beginning of the application process. For mortgages and auto loans, a down payment is typically a percentage of the full loan amount. While auto loans don’t always require a down payment, mortgages nearly always do. The smallest down payment options are attached to FHA and VA loans, which require between 3 percent and 5 percent down, with special programs available to make down payments as low as 1 percent available to qualified buyers. Conventional loans require 20 percent down in order to avoid mortgage insurance.
The principal balance is the unpaid portion of a loan or credit account excluding interest and fees. Your loan agreement should clearly define the amount of your monthly payment that goes toward principal and what goes toward interest and other fees.
Refinancing allows you to move debt to a new loan and/or change the terms of an existing loan. For example, many consumers refinance their mortgage loans, using their equity to pay off other loans such as credit cards, and/or to secure a lower interest rate or shorten the term of the new loan. It’s important to calculate the associated fees to ensure that the overall benefit warrants refinancing. In addition to mortgages, consumers can often yield benefits from refinancing student loans and car loans. This is often especially beneficial after credit repair efforts have raised a previously low credit score.
A cosigner is someone other than the primary borrower who assumes risk for a loan along with the primary borrower. Adding a cosigner to a loan is a way to increase the odds of approval, particularly if the primary borrower doesn’t have substantial income or a high enough credit score to qualify on his or her own. Cosigners are equally responsible for repaying the debt on which they’ve signed and are therefore putting their own credit score at risk if the primary borrower makes late payments or defaults on the loan.
Collateral is the asset or property used to secure loan repayment. Collateral value must be equal to or greater than the loan amount. The asset or property is then at risk of seizure (or repossession in the case of a mortgage or auto loan) by the lender in the event that the borrower defaults on payments.
Understanding these credit terms can remove some of the anxiety associated with the credit application process and help you manage your credit more effectively. If you’re struggling to qualify for any type of loan and wondering how to fix your credit you may benefit from working with a credit repair professional. Lexington Law offers a free credit report summary and consultation. Contact us today to get started.
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