Understanding Collateral in the 5 C’s of Credit
The 5 C's of credit in agriculture lending are a set of criteria used by lenders to evaluate the creditworthiness of borrowers. The collateral component is one of those C’S. It addresses the borrower's assets used as security for the loan.
What is Collateral?
Collateral refers to property or assets that a borrower can pledge as security for a loan. This can include real estate, equipment, livestock, vehicles, cash, or other assets. The lender holds the collateral until the loan is repaid. In the event of loan default, the lender can sell the collateral to recoup their losses.
Importance of Collateral in Credit Evaluation
Collateral helps lenders determine whether a borrower has sufficient valuable assets to secure the loan. When lenders evaluate a borrower's collateral, they are, in part, assessing the level of risk involved in extending credit. If borrowers have insufficient collateral, they are high-risk borrowers. Occasionally, a borrower with very strong credit factors will be unsecured, but that is limited to loans with shorter terms, like operating loans.
The borrower's collateral position will help determine the loan amount and interest rate. The more valuable the collateral, the higher the loan amount can be and the potentially lower the interest rate. The type of collateral required for a farm loan is based on the purpose of the loan and the length of the loan. Here are examples of collateral types for farm loans:
Types of Collateral
Farm operating loan: Secured by current and sometimes non-current assets. The current assets are generally inventories, receivables, crops, and young livestock. These assets will be sold or realized within one year of the loan origination. They are secured by a UCC issued by the state.
Equipment or livestock loans: Secured by intermediate-term assets like livestock, machinery, and equipment. These loans are generally five to seven years. Sometimes they are called “intermediate-term loans.” Often short-term and intermediate-term loans are “cross-collateralized,” meaning the loans share the same collateral pool. Like operating loans, these loans are secured by a UCC, except in the case of a titled vehicle; in that case, the title is security.
Real estate loans: Secured by real estate. These are long-term loans used to purchase real estate. The max term for farm loans is generally 20 years, though some exceptions depending on your lender (the FSA will lend up to 40 years). A mortgage or deed of trust secures real estate loans, depending on the real estate size.
How much can I borrow?
When determining a loan amount, lenders will calculate a loan-to-value ratio. This ratio takes the loan amount against the available collateral. Minimum requirements of loan to value (L/V) will vary based on your lender, but here are some general guidelines:
Loan to value ratio:
Operating Loan: 70%
Equipment loans: 80%
Livestock loans: 70%
Real estate loans: 60-65%
How to Improve Collateral
Here are some steps that borrowers can take to improve their collateral position:
Be prepared to make a down payment: You need enough cash to make the down payment required of sufficient other collateral to have the appropriate L/V.
Maintain and insure assets: Maintaining and insuring assets, such as land, equipment, and livestock, can increase their overall value and reduce the risk of damage or loss.
Keep detailed records: Having detailed records of all assets, including purchase price, maintenance costs, and insurance premiums, can help demonstrate the value of collateral to lenders.
Monitor collateral value: Regularly monitor the value of collateral and provide updated information to the lender.
Diversify assets: A diverse set of assets can increase collateral and reduce overall risk.
