Understanding the language of bankers is a crucial step toward achieving financial success.
In this guide, we will explore the essential terms that every aspiring investor and financier should know. By mastering these concepts, you will be able to start making informed decisions and begin navigating the complex world of finance with greater confidence.
Collateral: The Foundation of Financial Security
Collateral is a term that lies at the heart of lending agreements. In simple terms, it refers to a borrower’s pledge of specific property to a lender as security for repayment of a loan. This collateral provides protection to the lender in case the borrower defaults on their obligation to pay back the principal and interest.
At Fynanc we teach investors to use stable assets as collateral for loans. It’s essential to understand that lenders are not in the real estate business; instead, they are in the financing business, using real estate or other stable assets as a means to secure their loans.
The next vital terms on our list are LTV, CLTV, and protective equity.
Loan To Value (LTV)
Loan To Value is calculated by dividing the loan amount by the value of the collateral or property. For instance, if we loan $65,000 to a borrower against a property worth $100,000, the LTV would be 65% ($65,000 / $100,000).
The remaining 35% is known as “protective equity.”
This cushion serves as a safety net for lenders in case the borrower encounters financial difficulties. As lenders, we aim for low LTVs and high protective equity, which reduces our risk exposure.
Depending on the collateral type, we may set a maximum LTV—for example, 65% LTV for single-family residences—with 35% protective equity, indicating a secure loan structure.
Combined Loan To Value (CLTV) and Protective Equity
Let’s explore CLTV, which stands for “combined loan to value.”
Combined Loan-To-Value (CLTV) is similar to LTV, but it considers all existing loans against the property, including the amount the borrower is requesting. To calculate CLTV, divide the sum of all loans by the value of the property.
The formula for protective equity is simply 100% minus the CLTV percentage. So, for a CLTV of 85%, the protective equity would be 15%.
As lenders, we evaluate CLTV and protective equity to make informed decisions about loan approvals. For example, if the CLTV exceeds our maximum acceptable LTV (from the previous example), and the protective equity falls below the desired threshold, we would not approve the loan.
Throughout this guide, we’ll use the terms CLTV and LTV interchangeably. When performing calculations, refer to the CLTV formula for simplicity.
The Importance of LTV in Lending
The LTV ratio is one of the most crucial numbers in lending. For residential properties (1 to 4 units), it’s generally recommended to keep the LTV lower, typically around 65% or less. By maintaining a lower LTV, lenders can mitigate risk and secure their investment with sufficient protective equity.
What is a Promissory Note?
Promissory notes play a fundamental role in lending, acting as written promises from borrowers to repay a specific amount at a designated time, often with interest. These notes can be secured or unsecured, depending on whether tangible collateral backs them.
For instance, a “secured” promissory note includes collateral of value, offering protection to the lender in case of non-payment. In contrast, an “unsecured” promissory note lacks tangible backing, making it riskier for lenders. As a private lender, it’s far better to have secured loans, particularly those secured against real estate.
Promissory notes outline essential terms, such as the principal loan amount, interest rate, repayment schedule, due date (or maturity date), and penalties for late payments or early prepayment.
Securing Your Investment with Security Instruments
To secure your investment, lenders rely on security instruments recorded against the borrower’s property. In real estate, two common types of security instruments are a deed of trust and a mortgage.
Unlike bank deposits, which are often insured by federal agencies like FDIC, promissory notes involve some level of risk to the principal. They establish specific repayment periods and do not benefit from federal insurance.
The security instrument works in conjunction with the promissory note, tying the note to the property (the collateral). By doing so, the lender gains legal claim to the property in the event of borrower default.
What is Financial Leverage?
Financial leverage involves using borrowed money to acquire assets that generate cash flow. A classic example of financial leverage is getting a mortgage to purchase a property. Leverage can be a powerful tool for building wealth, but it must be used wisely to avoid potential pitfalls.
To understand wealth, one must grasp the concept of leverage thoroughly. The fastest way to accumulate wealth is through positive leverage, where borrowed funds are invested in assets that generate a higher return than the cost of borrowing. On the flip side, negative leverage can lead to wealth erosion, where borrowed funds are invested in assets that produce lower returns than the cost of borrowing.
What is Arbitrage?
Arbitrage is another important term to be familiar with.
It refers to the “spread” between the interest rate at which you borrow money and the rate at which you gain from investing that money. For instance, if you borrow money at 6% and invest it at 9%, you create a 3% spread, which is known as “arbitrage.” This strategy is commonly used in banking and can be an effective way to generate cash flow.
Velocity of Money
The velocity of money is a concept that is well-known in financial circles but less familiar to the general public. It refers to the rate at which money is exchanged from one transaction to another in an economy. For us, velocity of money is about “turning” the same money by investing it and then retrieving it to invest again. This can lead to acquiring more assets or profits without increasing the initial investment significantly.
Let’s take real estate as an example. If you have $100,000 as investment capital, you can choose between three properties.
- Property A generates positive cash flow, but ties up your capital for the foreseeable future.
- Property B may offer long-term appreciation potential, but still keeps your money tied up for a significant period.
- Property C allows you to resell quickly and repeatedly, making small profits each time and keeping the money “turning.”
This ability to reuse the same money efficiently is the essence of velocity of money. Velocity of money can be applied beyond real estate. For instance, by lending money secured by assets and continuously reinvesting the returned funds, you can increase your yield and generate more passive income.
Asset-Based Lending (ABL)
Asset-Based Lending (ABL) is a lending strategy that involves lending money secured by assets. This approach prioritizes the value of the collateral and ensures there’s enough to cover the loan. ABL is considered a safer lending practice compared to focusing solely on a borrower’s ability to repay.
At Fynanc, we believe that understanding these financial concepts and adopting the mindset of bankers can empower individuals to make smarter financial decisions and achieve financial success. We invite you to join us on this journey and deepen your knowledge by exploring our resources, including the free chapter of “The Banker’s Code” by George Antone.
Download your FREE chapter of The Banker’s Code by George Antone to deepen your understanding of the Banker’s mindset.
