If a lender obtains the right to take property, such as a plot of land, if the borrower does not repay his loan, the lender may also add a clause to the loan contract that states that the lender has the right to periodically inspect the plot of land to make sure that it retains its market value. This collateral inspection can occur according to a fixed schedule, and inspection may also take place if the lender thinks that the borrower is about to default on his loan.
A collateral inspection generally takes place before a bank agrees to the loan contract, and the bank may hire an independent professional, such as an appraiser, to estimate the value of a parcel of real estate. The appraiser charges a fee, which the bank may add to the balance of the mortgage if the borrower does not have the cash to pay the fee up front. The Federal Deposit Insurance Commission cautions lenders that basing the appraiser's fee on the value of the collateral is risky because it provides an incentive for the appraiser to overestimate the collateral's value.
The bank may also ask for a collateral inspection if the borrower asks to refinance, modify, or extend her loan. This creates a risk for the borrower that discourages her from modifying her loan, because if her property has lost value, it may no longer satisfy the bank's collateral requirements for the original loan.
The collateral inspection provides benefits for people who do not directly participate in the lending arrangement, according to the University of Chicago. Government agencies who levy taxes on the bank benefit, as well as contractors who perform work on credit or enterprises that sell products on credit to the bank. A third party real estate investor also benefits, because the bank determines the market value of the parcel, and this investor does not have to pay for the appraisal.
A bank may decide not to perform a collateral inspection if the borrower has other properties, and the loan contract allows the bank to use these assets as security for the loan if the original property loses value. According to the University of Chicago, adding new collateral to the loan is risky for the bank, because other lenders may also ask for more collateral from the borrower or ask him to agree to tougher contract terms on new loans, which could force the borrower into default.
- Idaho Soil & Water Conservation Commission: Resource Conservation and Rangeland Development Program Loan Procedure and Policy
- University of Chicago; Covenants and Collateral as Incentives to Monitor; Raghuram Rajan and Andrew Winton
- Federal Deposit Insurance Corporation: Bank Fraud and Insider Abuse
- Consumer Financial Protection Bureau. "1024.41 Loss mitigation procedures." Accessed Aug. 21, 2020.
Eric Novinson has written articles on Daily Kos, his own blog and various other websites since 2006. He holds a Bachelor of Science in business administration from Humboldt State University.