Question

Q49 - Collateral should never be the single determining factor in making the loan. Please explain.

Answer 1

Collateral is an asset or a security pledged as a securtiy for repayment of a loan, which can be forfeited in the event of a default. Collateral is one of the determining factors for borrowing a loan, however it should not be the single determining factor in making the loan. This lesson was learned the hard way during the crisis of 2008. One of the major reasons for the 2008 housing crisis was the fact that collateral was the single determing factor in giving out housing loans. Loans were given out to subrprime borrowers for which, the houses for which they were given loan for, was the only determining factor. This created a huge supply of houses when the borrowers defaulted on their loans, and due to the increased supply, the prices of the houses fell sharply, thus reducing the collateral value for the lenders to forfiet. Eventually, they were not able to recover their money and sufferred huge losses.

A number of factors should be taken into account when making a loan:

1) Credit score : The credit score is based on the past payment records and net worth of the individual or the organisation. A good credit score implies the borrower is highly likely to pay all the dues in a timely manner.

2) Regular income : Borrowers who have a regular and reliable source of income are highly likely to be good borrowers.

3) Capacity : Capacity measures the borrower's ability to repay a loan by comparing the income of an individual or organisation against recurring debts and assessing the borrower's debt-to-income (DTI) ratio.