Loans refer to money, material goods or property given by one party to another in exchange for a future repayment of the loan value amount, along with interest or finance charges. Loans often have specified time periods which could be a specific, one-time amount or could also be open-ended with credit up to a specific amount limit. Loans can be obtained from individuals, governments, corporate bodies or financial institutions.
Before loans are granted, each party has to agree to the terms of the loans which are usually drawn up by lawyers. If collateral is required by the lender, then it must be included as a clause in the loan’s terms. The loan terms also make provision for minimum and maximum interest rates as well as other covenants such as the maturity date of each loan and the timeline for repayment.
Loans consists of two types; they could either be secured or unsecured. Secure loans are backed by collateral; they include bank loans, mortgage payments and car loans. Just like the name suggests, unsecured loans have a higher risk rate for the lenders, and they have higher rates of interest to reflect this. They do not, however, have collateral backing and that means if the loan is not repaid it can lead to losses.
Assets Based Lending
Asset based lending refers to lending secured by an asset. That is, if a loan is not repaid, these assets are taken. Asset based lending is also known as collateral. Collateral refers to loan securities. They are payment guarantees to the lender in case of failed loan repayments. Collateral is required when applying for large loans as they improve the chances of such loans being approved.
Financial institutions and corporate bodies are unwilling to give out large loans without any form of security due to the fear of such loans becoming bad debt (i.e. they are not repaid). Pledging collateral means that by giving you such loans, the lender takes less risk and has a form of back-up in case the loan is not repaid on time, or at all.
This collateral gives the lender an assurance that they will not lose all of their money even if the loan repayments stop. If an asset is pledged as collateral, the lender has the right to take possession of such properties in situations where the loan payment is halted or if the loan has reached its maturity date. They take possession of these assets, sell them off and use the proceeds to repay the loan.
However, there are certain criteria that these assets must meet before they are accepted as collateral. They include:
- Value: The value of the assets must be up to or exceed the amount being loaned. That is the value of said assets must be equal to or higher than the amount to be repaid. The lender, on liquidating this asset, only takes the amount that is owned, while the excess is paid to the borrower.
- Assets should be freely transferable without legal, regulatory or any other constraints that would hinder liquidation.
- Assets should be denominated in the same currency as the loan, for easy management.
How Asset Based Loans Work
Asset based loans are a financing strategy used during loan applications. The borrower, by using his or her assets, can obtain loans from financial institutions. These assets are not being sold, instead they are borrowed against as collateral and the lender can only get control over them if payment defaults or is deferred. 70-85% of property value can be borrowed against; however, only 50% of equipment value can be borrowed on.
The interest rates on asset-based loans are far lower than those on unsecured loans because in this case, the lender’s risks are secured by the assets used as collateral. Interest rates on asset based loans are typically between 7-17%, depending on the size of the loan. Asset based loans are very flexible in terms of repayment.
Problems With Assets Based Lending
- Not all assets qualify as collateral: While assets based lending accepts assets as collateral, not all assets do qualify for collateral. Lenders often times have certain qualifications to be met before assets qualify as collateral.
That is to say that some assets are considered more valuable to the lender than others. More recently, accounts receivables have been used as loan collateral. However, if these receivables are not strong enough, then assets would need to be used instead. The assets have to be of high value with high appreciation rate or low depreciation rate.
- Higher Costs: Asset based loans cost a lot more than other traditional loans. Some financial institutions require a lot more information about the asset being used as collateral. That is because they will need information on the current value and depreciation value of these assets.
Gathering this knowledge is an acquired cost thus increasing the cost of the loan. Some banks charge audit fees as well as interest rates on loans. This makes asset based loans considerably more expensive than traditional loans, which banks only charge interest rates on.
- Devalued Collateral: the lender often looks for an asset that can be quickly converted into money in cases where the borrower defaults on payments. Thus it means that the value of the collateral would be reduced by the lender. This is so that if the borrower defaults on his payment, then the lender could easily liquidate the assets to regain the cost of his loan.
- Loss of Valuable Assets: The borrower sometimes has to let go of valuable assets in cases of defaulted payments, which the lender has to liquidate easily and hence they have to price them for a quick sale.
While it is possible to take loans against your assets, it is however much more complicated as there are risks and terms involved before these assets can be considered viable collateral. Therefore, it is necessary to consider the extra costs as well as other complications that might come with acquiring these loans before applying for them.