What is Collateral Coverage Ratio?(Implications for Liquid Loans)

Collateral coverage ratio is a metric used to assess the level of protection that lenders have against possible loan defaults.

It is used to determine how much collateral a borrower has pledged relative to the amount of the loan.

In simple terms, it is the ratio of the value of the collateral to the loan amount.

Understanding the Importance of Collateral Coverage Ratio

Collateral coverage ratio is a critical factor in determining the creditworthiness of a borrower.

A high collateral coverage ratio implies that the borrower has pledged sufficient collateral to protect the lender's investment in the event of a default.

On the other hand, a low collateral coverage ratio implies that the borrower has not pledged enough collateral, which increases the risk of the lender's investment.

Collateral Coverage Ratio Calculation Formula

The collateral coverage ratio is calculated by dividing the value of the collateral by the loan amount.

Value of Collateral / Loan Value

For example, if a borrower pledges collateral worth $50,000 for a loan of $100,000, the collateral ratio would be 0.5.

What is a Good Collateral Coverage Ratio?

A good collateral coverage ratio varies depending on the lender's risk tolerance and the industry's specific requirements.

Generally, a collateral coverage ratio of 1.0 or higher is considered good.

This means that the value of the collateral pledged is equal to or greater than the loan amount.

However, some lenders may require a higher collateral coverage ratio, especially for high-risk loans or industries.

It is essential to check with your lender to determine the specific collateral coverage ratio requirements for your loan.

Types of Collateral Coverage Ratio

There are two types of collateral coverage ratios: loan-to-value ratio (LTV) and debt service coverage ratio (DSCR).

Loan-to-Value Ratio (LTV)

Loan-to-value ratio is the ratio of the loan amount to the appraised value of the collateral. It is a measure of the percentage of the collateral that is being financed by the loan. For example, if a borrower pledges collateral worth $100,000 for a loan of $80,000, the loan-to-value ratio would be 0.8.

Debt Service Coverage Ratio (DSCR)

Debt service coverage ratio is the ratio of the borrower's cash flow to the debt service obligation. It is a measure of the borrower's ability to repay the loan. For example, if a borrower has a monthly cash flow of $5,000 and a monthly debt service obligation of $4,000, the debt service coverage ratio would be 1.25.

Why Collateral Coverage Ratio Matters

Collateral coverage ratio matters because it provides lenders with an indication of the level of risk associated with a particular loan.

If a borrower has a high collateral coverage ratio, the lender can be reasonably confident that the borrower will be able to repay the loan, even in the event of a default.

If a borrower has a low collateral coverage ratio, the lender may be hesitant to extend credit because of the increased risk.

Collateral Coverage Ratio in Liquid Loans

Liquid Loans allows users to collateralize their PLS and mint USDL stablecoin.

The collateral coverage ratio of the Liquid Loans protocol is designed to always be overcollateralized or above 1:1. 

In fact, if the total collateral ratio of the system falls below 3:2, then the system enters recovery mode. 

Individual vaults must hold a collateral ratio above 1.1:1 or they risk being liquidated.