What is an Advance Rate?

What is an Advance Rate?

An advance rate is the percentage amount of the value of the collateral that a lender is willing to extend as a loan. The risk to a lender is minimized in a default by using an advance rate, particularly when accepting collateral that fluctuates in value.

An advance rate is the percentage of the value of the collateral that a lender is willing to extend as a loan. The advance rate helps a borrower determine what kind of collateral to bring to the table to secure the desired loan amount and helps minimize a lender’s loss exposure when accepting collateral that can fluctuate in value.

An advance rate is the percentage amount of the value of the collateral that a lender is willing to extend as a loan.

The risk to a lender is minimized in a default by using an advance rate, particularly when accepting collateral that fluctuates in value.

An advance rate also benefits a borrower in that it typically allows for a better interest rate on the loan or a larger loan.

Common collateral for an advance rate can include real estate, automobiles, cash accounts, investments, and insurance policies.

Determining the advance rate goes hand in hand with assessing the credit risk of a borrower.

Understanding an Advance Rate

Collateral helps lenders minimize risk and offer affordable interest rates to borrowers. By setting an advance rate, a lender can build a cushion into the loan transaction by ensuring that if the value of the collateral drops and the loan goes into default, there is still adequate protection from the principal loss of the loan.  If a lender has an advance rate of 75%, and the value of the collateral presented is $100,000, then the maximum loan the borrower can receive is $75,000.

Collateral helps borrowers secure a better rate for their loan and potentially a larger loan altogether. Common types of collateral include real estate (including home equity), automobile vehicles, cash accounts, investments, insurance policies, future payments or receivables, valuables, or machinery and equipment.

The advance rate works similarly to the loan-to-value (LTV) ratio. LTV is another lending risk assessment ratio often used by financial institutions and other lenders prior to approving a mortgage.

High LTV ratios are generally deemed to be higher risk, subsequently costing the borrower more and potentially requiring the borrower to purchase mortgage insurance. The LTV ratio can be calculated as the Mortgage Amount / Appraised Value of the Property.

See also :  What is Expected Default Frequency (EDF)?

How Does an Advance Rate Work?

When determining the advance rate, lenders assess the risk of providing a loan to a specific borrower. After a full financial review is complete, lenders will then determine the advance rate. Lenders also consider the type of collateral, which the borrower is able to choose.

The advance rate may be different if land is being used as collateral versus if a developed lot is used to guarantee the loan. Likewise, when lending to a business, the advance rate may be higher when accounts receivable are used as collateral versus when inventory is used as collateral.

Once a lender has determined the advance rate, they can approve the borrower for a loan equaling an appropriate percentage of the collateral. For example, if the collateral was a plot of land worth $100,000 and the advance rate was 80%, the lender could approve the borrower for a loan valued up to $80,000 (as long as the borrower met all other qualifying criteria).

Formula for the Advance Rate

The advance rate formula is presented below:

advance rate  = maximum loan vale / collateral value x 100

Why do advance rates matter?

As Ali Hamed has pointed out, borrowers often put too much emphasis on the interest rate of their debt raise and fail to appreciate the importance of their advance rate when it comes to profitability. As Hamed notes, a 10% advance rate difference can have serious implications on a fintech’s profitability, even if all other payback variables (e.g., size of loan book, repayment profile) are identical.

This is because having a higher advance rate enables a borrower to fund originations without having to tie up cash on its own balance sheet. This is intuitive; being able to lend to consumers with the capital provider’s funds enables a fintech company to use its own money for other purposes.

From a capital provider’s perspective, an advance rate might be viewed as the amount of exposure that the capital provider has to receivable underperformance. The higher the advance rate, the more the capital provider stands to lose if a portfolio of receivables underperforms.

Think of it this way—if the advance rate on a receivable-backed credit facility is 80%, a capital provider can withstand up to 20% in receivable defaults (which are borne by the credit facility borrower) before seeing any losses on principal. If the advance rate is 90%, the capital provider has only a 10% cushion.

See also :  What is a Call Loan?

Advance Rate in the Context of Assessing Credit Risk

Determining the advance rate for a borrower usually comes after the lender analyzes the overall financial condition of the borrower. This analysis focuses on the ability of the lender to repay the proposed loan, according to the specific terms and conditions given.

To determine a borrower’s credit risk, lenders, such as commercial banks, often begin with a framework, called “the five Cs.” These consist of an applicant’s credit history, their capacity to repay, their capital, the loan’s conditions, and associated collateral. Once these factors are taken into consideration, the collateral is then appraised. Once appraised and the value determined, the advance rate is decided.

Credit risk assessment occurs not only in cases of consumer loans but also throughout the bond market. Following careful consideration of a bond issuer’s risk of default, a credit rating agency, such as Fitch, Moody’s, or Standard & Poor’s, assigns a rating, which corresponds to the issuer’s risk level and corresponding potential for reward.

What is an effective advance rate?

One way to think about the stated advance rate is as the percentage of every dollar (in portfolio value), that a borrower can draw against. This is also the maximum advance rate, because credit agreements often outline a number of situations in which a borrower would not get full credit for its receivables.

For example, a borrower with $1 million in current receivables and an advance rate of 80% could borrow $800,000. However, if half of those receivables were delinquent, the borrower might only be able to borrow $600,000. In that instance, its effective advance rate would be 60%. This is because the quality of the borrower’s collateral has declined.

It makes sense that a capital provider would not give full credit for delinquent receivables; different types of receivables should count for different amounts of credit. (In practice, the amount of credit a borrower can get for a delinquent receivable is defined in the credit agreement and negotiated between capital providers and borrowers prior to the execution of the debt raise.)

In this sense, the effective advance rate is a scorecard that tracks the quality of a borrower’s portfolio of receivables, according to the guidelines/KPIs defined in the credit agreement.

See also :  What is a Mortgage Bond?

Advantages and Disadvantages of Advance Rates

Lenders use advance rates to protect against loss. If a borrower is limited to a loan valued at 80% of the estimated value of collateral, the lender has reduced its risk, because it knows the borrower has the ability to pay the balance.

The collateral could drop in value and be worth up to 20% less and it would still be valuable enough to ensure the lender could collect the full outstanding loan balance in case of default.

Advance rates benefit lenders. However, lenders may have to do some work to assess the value of collateral. For example, they may have to conduct an audit on the quality of a borrower’s accounts receivable if their outstanding accounts are to be used as collateral to guarantee a loan. This can be a disadvantage because it makes the loan approval process more complex and time-consuming.

While advance rates do allow borrowers to set the collateral, which can be seen as an advantage, advance rates can often disadvantage borrowers by limiting the size of their loan relative to the collateral. For example, let’s say an advance rate is set at 80% for a borrower who put their land—valued at $100,000—as collateral. If that borrower wants to borrow $100,000, they would not be approved for the full amount of the desired loan. It would be capped at $80,000.

How can software help borrowers optimize their effective advance rate?

As mentioned above, an effective advance rate is like a scorecard for a borrower. The closer the effective advance rate is to the stated advance rate, the better a borrower is doing when it comes to ensuring the quality of its portfolio of receivables, and the more profitably the borrower can operate.

The right software can help debt capital borrowers monitor their collateral value in near real time, centralize record-keeping on amount of capital drawn, and send alerts when an effective advance rate falls below predefined thresholds.

Without a software foundation for debt capital management, borrowers run the risk of underutilizing their debt capital and miscalculating their unit economics—even if their portfolios perform as expected.