Undercollateralized

Undercollateralized describes a loan or credit arrangement in which the value of the collateral backing the obligation is not sufficient to cover the outstanding exposure. In such a case a portion of the loan remains unsecured by collateral, and the lender bears a higher risk of loss if the borrower defaults. The term is often used in contrast to over-collateralized loans, where collateral exceeds the loan amount, and to unsecured loans, which carry no collateral at all.

A common way to measure collateral adequacy is the collateral ratio or loan-to-value (LTV) ratio. The collateral ratio compares the collateral value to the loan amount, while LTV expresses the loan as a percentage of the collateral value. An undercollateralized loan typically has a collateral ratio below a targeted minimum set by the lender. For example, a loan of 100,000 secured by 60,000 in collateral has a collateral ratio of 60% and an LTV of about 167%, indicating undercollateralization relative to many conventional lending standards.

Risks associated with undercollateralized loans are higher for lenders, including greater potential loss in a default, reduced liquidation efficiency, and higher funding costs. These risks often lead lenders to charge higher interest rates, require rapid margin calls, or seek additional protections and covenants. In stressed markets, undercollateralization can contribute to broader liquidity and solvency concerns for lenders and financial systems.

In traditional finance, undercollateralization is managed through pricing, credit enhancements, additional collateral requirements, or by shifting such loans to riskier segments. In decentralized finance, most platforms rely on over-collateralization, while undercollateralized lending remains an area of ongoing research and development.