A haircut in finance has a few different meanings. In terms of a loan, a haircut is the percentage difference between the amount of the loan and the market value of the asset being used as collateral for the loan.
Here's what you need to know about the term haircut and how it may relate to your finances.
Definition and Examples of a Haircut
If you’ve ever had to put something up as collateral to take out a loan—like a home or car, for example—there’s a value placed on that asset. When financial institutions borrow from one another, they can use other loans or assets as collateral to borrow, too.
A haircut refers to the percentage difference between the amount of the loan given and the value of the asset used as collateral.
For example, let’s say small bank A needs to borrow from big bank B. Small bank A wants to borrow $500,000 and puts up assets as collateral to borrow that loan. Big bank B values those assets at $375,000—or 25% less than the loan amount. The 25% difference is the haircut.
- Alternate definition: The term “haircut” may also be used in investing. The difference between a buying and selling price of a share is known as the “spread,” but it is sometimes referred to as a haircut when it is so thin. Another phrase used often is “to take a haircut,” which means to take a loss on an investment.
How a Haircut Works
A haircut appears when a financial institution places a value on a collateral asset that is lower than the requested loan amount. A lender will determine the haircut amount—usually a percentage difference—and it varies by institution and instance. The lender determines the haircut amount by calculating the risk involved.
If a lender determines there’s a high risk of loaning to the borrower, they might increase the haircut amount compared to an asset or loan that has lower risk. When a lender devalues an asset, they increase their protection in case the market value drops. If a lender ever needs to sell an asset because the borrower defaults, they calculate how much they can reasonably expect in a sale. That’s usually the value they place on the asset.
Since every asset is treated differently, haircuts don’t have a one-size-fits-all percentage. One asset could be worth $10,000 but given a haircut of 10%, meaning it’s treated as though it has a value of $9,000. Another asset could be worth $10,000, but given a haircut of 30%, meaning it’s treated as though its value is $7,000.
The lower the haircut, the safer the asset. The higher the haircut, the more volatile the asset is or would be in the event the lender has to sell it.
What It Means for Investors
While we’re looking at haircuts in terms of loans, the term is sometimes used in investing. Keep an eye out if you ever need to borrow on margin from a brokerage firm. When you borrow a margin loan, your broker will put a value on the securities used as collateral for that loan. The larger the haircut, the lower the value of those securities you put up as collateral. This gives the brokerage a larger cushion in case the market price of the securities decreases.
Since a haircut also refers to the difference in the buying and selling price of an asset, if you were to buy 100 shares of company ABC for $100 per share (a total cost of $10,000) then sell those 100 shares a moment later, you might see that you’d only get $90 per share, for a total of $9,000. This is because of market makers. The 10% difference in price is the haircut, which is the fee market makers charge to offset risk. This may happen if you hope to buy and sell shares quickly. Market makers help provide that liquidity.
- A haircut is the difference between the loan amount and the value of an asset used as collateral.
- A brokerage, lender, or other type of financial institution determines the haircut based on the asset, the market at the time, and the level of risk involved.
- The higher the haircut, the lower the asset value. Assets that are extremely volatile, such as stocks, might have a higher haircut compared to other types of securities.
- Haircuts also refer to the difference in a selling price and what the buyer pays for a stock. The difference—or haircut—usually comes down to fees and charges associated with the transaction, often in association with market makers.
- You may also see the phrase “ to take a haircut,” which means to take a loss on an investment.