The Debt to Collateral Ratio

To get a loan at the best possible interest rate, you often have to pledge a valuable piece of property as collateral so the lender can recoup some of her money if you default on the loan. Whether you are borrowing money to pay for a house or car or to expand your business, understanding how lenders evaluate loan applications will increase your odds of securing the funds.

A collateral is an asset that belongs to the borrower that the lender can legally seize in case of default. The most common example is a house bought with a mortgage loan. Although the house belongs to you, the lender can seize the house and sell it if you fail to make monthly mortgage payments. A collateral cannot be sold without the permission of the lender, and the borrower is usually required to look after the collateral to ensure it does not lose a great deal of its value. If the collateral is a house or a car, it is usually mandatory to carry insurance on it.

Regardless of the type of loan, the value of the asset pledged as collateral is usually greater than the amount the lender is willing to lend. If you wish to take out a bank loan to purchase a car worth $10,000, very few banks, if any, will lend you the full $10,000. Instead, they may lend anywhere from $7,000 to $9,000. The car is the collateral in this case, as the bank would have a right to seize it in case of default. What portion of the collateral's value you can borrow is known as the debt to collateral ratio, which equals the total amount of debt divided by the assessed value of the collateral you pledge. If the bank is willing to extend an $8,000 loan for the purchase of a $10,000 car, the ratio is $8,000 divided by $10,000, which is 0.8.

The debt to collateral ratio is critical from the lender's perspective, as it will determine the probability of recovering the loan in case of default. If the ratio is high, the amount you owe is close to what the collateral is worth. Such would be the case if you borrow $9,500 for a car worth $10,000, resulting in a ratio of 0.95. Should the value of the vehicle drop by 10 percent, to $9,000, because of a mechanical problem, the loan's value will exceed the value of the car. If you default on the loan, the bank won't recover what it is owed by seizing and selling the vehicle.

Since lenders prefer a low debt to collateral ratio, the smaller the loan in relation to the collateral's worth, the easier it is to get approved for the loan and the lower the interest rate. However, the lower the ratio, the more you have to pay out of pocket. While it is easier to borrow $7,000 than $9,000 when buying a car worth $10,000, you must put $3,000 down in the first case, while you need only $1,000 in the second scenario. Therefore, borrowing against a collateral is always a case of finding the ideal balance between ease of qualifying and interest expense against down payment.