Advance Rate - Explained
What is an Advance Rate?
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What is an Advance Rate?
An advance rate is a percentage of the value of the collateral set by the lender, up to which the lender agrees to extend the loan amount. When a lender provides a loan against collateral that has a fluctuating value, the lender needs a predetermined advance rate to protect themselves from loss. Depending on the advance rate, the borrower decides what collateral to be provided to secure the desired amount of loan.
How Does an Advance Rate Work?
Lenders accept collateral as a security for a loan to reduce the loss exposure. If the borrower fails to repay the loan, the lender can sell that asset to recover the loss. The loans with collateral are offered at a much lower rate than the unsecured loans. If the asset that is being provided has a fluctuating value, the lender set an advance rate to minimize the risks such as the depreciation of the collateral. If the borrower fails to repay the loan and the value of the collateral reduces, the advance rate ensures the lender can still recover the principal amount of the loan by selling the collateral. For example, let's assume the advance rate of a loan is set as 90% by the lender. Now, if the borrower provides the collateral the value of with is $10,0000, the maximum loan the borrower will receive against that collateral is $90000. The common collateral that is used in securing loans is automobiles, insurance policies, cash accounts, real estates, future payments and machinery, and equipment. Some of these collaterals have depreciating value. The advance rate protects the lender against that value fluctuation. The lender analyzes the financial condition of the borrower before determining the advance rate. The ability of the borrower to repay the loan is assessed. Usually, the borrower's credit risk is calculated by the lender using "the five Cs" framework- Credit history of the applicant, applicant's capacity to repay, capital of the applicant, conditions of the loan and the collateral. After analyzing and assessing the applicant's credit risk, the advance rate is determined by the lender. If the present collateral doesn't cover the required loan amount, the borrower either have to compromise with a lower amount or needs to provide some other collaterals.