Collateral is something pledged by the borrower to secure the performance of a loan. Typically, when a lender makes a loan, the borrower signs a note and either a mortgage or deed of trust which encumbers a piece of real estate that serves as collateral. This is what we see in the vast majority of residential and business real estate transactions.
It is incumbent upon the lender to verify the true value of the collateral and that the collateral is properly described in the loan documents. The lender must also verify via a recent title examination that the collateral has no other encumbrances which would diminish the value of the collateral below the reasonable safety margins established by the lender.
Lenders in the residential, non-owner-occupied real estate space will typically lend to investors at a 65-75% loan-to-value (LTV) ratio. In case you aren’t sure what LTV is, let me give you an example. If I’m lending you $75,000 on an asset worth $100,000, I have a 75% LTV, so I have a little cushion to cover a decline in property value plus any costs of enforcement, foreclosure or collection should the borrower default on the loan. Have I lent and borrowed below and above that range? Yes, but that range is generally accepted as normal for LTV.
Here are the three most common types of collateral and the loan document we would use for each:
- Real estate (mortgage or deed of trust)
- Personal property (UCC-1)
- Membership units in an LLC or corporation (membership or share pledge agreement)
Unless you are an advanced investor with a great deal of experience and have done very good due diligence on your borrower, whom you have known for quite some time, I strongly recommend that you don’t do anything other than lend with real estate as collateral. If the borrower is well known to you, their reputation and integrity are solid, and they have a good business model which you understand, you can lend with personal property or membership units in an entity as collateral.
