Advance rate determines how much money a lender will lend a borrower relative to the value of the borrower's collateral. Collateral—or an asset of the borrower, often colloquially called “skin in the game”—guarantees the loan, as the lender can take the collateral and resell it to get paid back in case of default.
Definition and Examples of Advance Rates
An advance rate caps the balance of a loan at a specific percentage of a borrower's collateral. For example, if a lender is providing a loan to a business, the company may use their accounts receivable as collateral to guarantee the loan. The lender might cap the amount of the loan at 70% of the value of eligible receivables.
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.
Typically, advance rates differ for each collateral type. Common types of collateral include real estate such as developed lots, homes under construction, or land, as well as vehicles, cash accounts, investments, or other valuables.
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.
A borrower may choose to select collateral that is high in value rather than an asset that is not high in value, thus increasing the amount of the loan offered through the advance rate.
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).
Lenders may require the borrower provide a borrowing base certificate periodically to show the value of the collateral is maintained relative to the loan balance.
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.
- An advance rate sets the maximum loan limit by a lender relative to the value of collateral, and serves as protection for lenders.
- Advance rates determine what percentage of the collateral's value can be lent out to borrowers.
- Advance rates can differ depending on the type of collateral and the borrower's financial profile.