What is an advance rate?
A cash advance rate is the percentage of the value of the collateral one lender is ready to make a loan. The advance rate helps a borrower determine what type of collateral to bring to the table to secure the desired loan amount and helps minimize a lender’s risk of loss when accepting collateral that can fluctuate in value.
Key points to remember
- A prepayment rate is the percentage of the value of the collateral that a lender is willing to give in the form of a loan.
- The risk to a lender is minimized in the event of default by using a prepayment rate, especially when accepting collateral that fluctuates in value.
- An early rate also benefits the borrower in that it usually allows for a better interest rate on the loan or a larger loan.
- Common guarantees 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 a borrower’s credit risk.
Understanding an advance rate
Collateral helps lenders minimize risk and provide interest rate to borrowers. By setting a rate upfront, a lender can build a cushion in the loan transaction by ensuring that if the value of the collateral drops and the loan goes into default, there is always adequate protection against the principal loss of the loan. If a lender has a prepayment rate of 75% and the value of the collateral presented is $ 100,000, the maximum loan the borrower can receive is $ 75,000.
The collateral helps borrowers get a better rate on their loan and potentially a larger loan. Common types of collateral include real estate (including home equity), motor vehicles, cash accounts, investments, insurance policies, future payments or receivables, valuables or machinery and equipment.
The advance rate works the same as the loan-to-value ratio (LTV). LTV is another loan risk assessment ratio often used by financial institutions and other lenders before approving a mortgage. High LTV ratios are generally considered to be higher risks, which in turn costs the borrower more and potentially requires them to purchase mortgage insurance. The LTV ratio can be calculated as the mortgage amount / the appraised value of the property.
Advance rate in the context of credit risk assessment
Determining a borrower’s prepayment rate usually comes after the lender has analyzed the borrower’s overall financial situation. 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 credit risk, lenders, such as commercial banks, often start with a framework, called “the five C’s.” These are an applicant’s credit history, repayment capacity, principal, loan terms and associated collateral. Once these factors are taken into account, the guarantee is then assessed. Once assessed and the value determined, the advance rate is decided.
Credit risk assessment takes place not only in consumer loan cases, but also bond market. After careful consideration of the default risk of a bond issuer, a credit rating agency, like Fitch, Moody’s or Standard & Poor’s, assigns a rating that corresponds to the risk level of the issuer and the corresponding reward potential.