What two instruments are commonly used to secure the purchase of real property?
An asset that is pledged as security to a lender by an individual or a business to support a borrowing request Show
What is Collateral?Collateral is an asset pledged by a borrower, to a lender (or a creditor), as security for a loan. Borrowers generally seek credit in order to purchase things – it could be a house or a car for an individual, or it could be manufacturing equipment, commercial real estate, or even something intangible (like intellectual property) for a business. If loan exposure is supported by collateral, it’s said to be secured credit; if it is not secured by collateral, the exposure is said to be unsecured. While collateral will make a sound borrowing request more secure, having collateral available does not serve as a substitute for other risk management and loan underwriting best practices. Summary
How Does Collateral Work?An asset becomes collateral security when a lender registers a charge over it, either by using a fixed or a floating charge. These charges are also known as liens. Examples of fixed charges include a collateral mortgage over a specific property or the registration of a charge over a unique identifier, like the serial number of a specific vehicle. Once a security charge is registered over a physical asset, the borrower cannot sell that asset without the lender first discharging its security interest. A floating charge is very common with business borrowers and is often registered using something called a General Security Agreement (GSA). A GSA covers all the assets of a borrower not otherwise named in a specific security registration (like our property or vehicle examples). GSAs allow lenders to take otherwise difficult-to-identify assets (like inventory) and use them as collateral to help backstop credit exposure. Charges are filed with a public registry, which varies by jurisdiction. The public registry allows stakeholders to see and understand who has claims over which assets and in what order those claims were filed. In general, charges that are filed first usually have “higher priority” than charges registered later (or “behind”) them. They are often referred to as “higher ranking” claims or claims that are more “senior” than those below them. Understanding Collateral ValueThere are two ways to think about collateral “value.” The first is its relative desirability; the second is its monetary value – although both are subject to market forces. How “Desirable” is the Asset?A useful tool to help conceptualize the overall desirability of collateral is the MAST framework. MAST stands for Marketable, Ascertainable, Stable, and Transferable.
Collateral assets that score highly against these MAST criteria tend to command more flexible loan terms, like longer amortization periods, lower interest rates, and higher loan-to-values (LTV). What is the Asset Worth?An asset’s monetary value could mean a number of things. Book value is one measure that’s commonly used to understand what inventory or accounts receivable are worth for the purposes of extending credit. If a business is acquiring fixed assets (like property, plant and equipment), it would be common to use the purchase price as the “value” when calculating loan-to-value. For used equipment, a third-party appraiser is often hired to assess that asset’s value. Equipment appraisers will often provide three “values” when preparing a valuation report. These are:
What is Collateral Used for?Once a creditor’s full loan exposure has been repaid (either by the borrower making payments or through refinancing by a different lender), the original creditor’s claim is “discharged” by its legal counsel. If a borrower defaults on a loan payment to a lender, however, and the credit exposure cannot be refinanced with another firm, that lender can sell the asset (or assets) over which they have a charge in order to recover outstanding funds, plus any accrued interest. As noted earlier, assets are seized and liquidated in the same order of priority that the security charges were made. In some liquidation scenarios, collateral assets are sold at auction for more than is owed to the creditors. In this case, surplus funds beyond the balance of outstanding credit plus accrued interest would be distributed to common stockholders of the business. Additional ResourcesThank you for reading CFI’s explanation of collateral. To keep advancing your career, the additional CFI resources below will be useful:
What are considered security instruments?A security instrument is a legal document giving the bank a security interest in the property. It can be a mortgage, giving the lender a lien on the property, or a deed of trust, whereby a trustee holds the deed for the lender until you finish paying off the loan.
What financial instrument is often used when special problems arise in the financing of real estate?What financial instrument is often used when special problems arise in the financing of real estate? contract for deed.
What provides the evidence of debt?Evidence of debt means a writing that evidences a promise to pay or a right to the payment of a monetary obligation such as a promissory note; bond; negotiable instrument; loan, credit, or similar agreement; or monetary judgment entered by a court of competent jurisdiction.
Does mortgagee have legal title?Rights of the mortgagee
In relation to unregistered land (pre-1926 mortgages), the mortgagee has the right to possession of the title deeds of the property. This is because possession of the title deeds represents the legal estate, and of course, in pre-1926 mortgages, there must be a transfer of a legal estate.
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