In this case, if the total outstanding value of the accounts receivable was $50,000, the maximum amount of the loan would be $35,000. Lenders set advance rates to ensure they are protected from risk. It’s especially important for lenders to do this when the value of the collateral is uncertain or when the value of the collateral could change. The goal is to make absolutely sure the collateral is actually worth enough to guarantee the loan will be paid back in full. Advance rate is similar to loan-to-value ratio, which caps the amount of mortgage loan at a certain percentage of what the collateral is worth. For example, lenders may cap a home loan at a specific percentage of the property’s appraised value.
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).
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.
