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4 min read. February 3, 2022 – by Jacinta Sherris
When applying for a business loan, expect to have to provide your credit history, tax returns, revenue levels, and more. Oftentimes, you may even be asked for collateral, especially if you’re working with a traditional lender, such as a bank. In this article, we will discuss collateral in business and everything that you need to know about it.
Lenders want to mitigate their risks as much as possible. They do this by making sure your business’s financials are in good standing and that you’ll be able to repay your loan. In the event you’re unable to make payments, collateral can act as a safety net – allowing lenders to recuperate their funds.
Fortunately, not all lenders require collateral in exchange for business financing. We’re going over exactly what is collateral in business financing, its pros and cons, and ways to get funding without it.
Collateral in business refers to a personal property or any type of valuable asset that a borrower provides to a lender in order to secure a loan. A collateral serves the purpose of reducing risk for lenders, ensuring that the borrower will repay their loan on time. Some collateral examples may include inventory, real estate, Accounts Receivable, cash & equivalents, etc.
Other personal assets can also be used as collateral. With certain types of collateral, especially real estate, an appraisal may have to be completed by a third-party to verify the asset’s value.
Collateral helps ensure borrowers meet their financial obligations and that the lender will be repaid. It’s essentially an insurance policy for your loan. In case you default on your business loan or you’re unable to make payments, the lender can claim your asset.
They may sell it and exchange it for cash to recuperate their funds. What’s most important for lenders, is that they’re able to quickly and easily liquidate the asset.
One of the most popular types of collateral loans are home mortgages. With this type of financing, the property is guaranteed to the mortgage company or bank if the homeowner can’t meet their payment obligations.
Collateral is also popular in the world of business financing. Collateral in business loans can boost a borrower’s chances of approval and even help them secure higher funding amounts and lower interest rates. Despite the benefits, this type of financing can present additional risks for borrowers.
Keep in mind that whichever type of collateral you use, it’s unlikely you’ll be able to use the full value amount. Most lenders issue more than 80% of an asset’s value. Business loans that are backed by collateral are also sometimes called asset-backed financing or secured loans.
Business loans that are backed by collateral are also sometimes called asset-backed financing or secured loans.
The 5 most common types of collateral in business include real estate, business equipment or machinery, inventory, invoices and investments, as long as they have a recognized value associated with them. If they don’t have a substantial value, or it can drastically decrease over a short period of time, they won’t be able to secure the repayment.
Real estate is one of the most popular forms of collateral in business. Lenders appreciate real estate because it holds value well over time and is also typically worth hundreds of thousands of dollars. Which can help you secure higher funding amounts.
You can use any form of real estate you or your business owns. But make sure to thread carefully before agreeing to use your primary residence as collateral. If you’re unable to repay your business loan, you could risk losing your home.
Business equipment or machinery is another favorite form of collateral among lenders. Equipment tends to be high in value, and readily available in manufacturing or construction businesses.
However, machinery can decrease in value over time. If you have machinery that has significant wear and tear, it may be difficult to secure a high funding amount.
Many merchants or retail stores oftentimes opt to use their inventory as collateral. While this can be a great way to secure a loan, some lenders may be hesitant to accept inventory – especially if certain items are difficult to sell off for cash.
Many businesses are cash-strapped because of late payments and outstanding invoices. In fact, there’s an entire branch of financing, called invoice financing, dedicated to these scenarios. Invoices can also be used for collateral and can be a great way to get much-need cash quickly.
Investments, such as stocks and bonds, can also be used as collateral for business loans. They tend to be very liquid because they can be sold off quickly – making them a favorite among lenders. You can opt to use either your business’s investments or your own to secure a loan.
The main downside is that, in the event of a market crash, you could find yourself in a problematic situation if your investments drop in value below your outstanding loan balance.
Some examples of collateral in business include:
You can opt to use your office, store, warehouse, private residence, or another property as real estate collateral. Once you apply, you’ll need to work with the lender to have the property appraised. The amount it appraises for will ultimately determine how large your business loan can be.
This process can take some time. If you’re working with a traditional lender, like a bank, it may go on for weeks or months. However, online lenders can be significantly faster. After the property is appraised, you may be required to purchase insurance to protect the lender’s interests.
Once your business loan is approved, you’ll continue to make payments on it the way you would with a regular loan. You can also continue to use the property in more the less the same way you were using it before.
If you’re occasionally late with payments, your credit score will take a hit but you won’t necessarily be at risk of losing the property. However, if you default, the lender will have the right to seize your real estate.
Many business owners will use their stock, bond, or other investment portfolios as collateral for a business loan. Lenders are typically willing to accept investments as collateral because they are liquid and can be sold off easily.
However, you shouldn’t expect to receive the full value of your assets to count towards collateral. Most investors will have a cap at the 80% mark or less. This helps them stay protected in case your portfolio drops in value.
In fact, the greatest risk to these types of loans is if your investments drop in value and you’re asked to make up the difference.
Some lenders will maintain collateral requirements for financing. Other times, borrowers may opt to put down collateral on their own accord. By making themselves appear less risky to the lender, collateral can help borrowers secure lower interest rates, higher funding amounts, or more favorable terms.
Collateral can also help you obtain funding faster and easier. This is especially true if your business is relatively new, if your credit is lower, or if your financial qualifications are lacking in some other way.
While putting down collateral has its benefits, there are also important drawbacks to consider. Most significantly, you risk losing your property if you default on your loan. If you’re using your home or another valuable asset, you could quickly find yourself in a precarious financial situation.
Additionally, not all businesses will have access to valuable property they can use as collateral. This is especially true among younger businesses or startups, which may exclude them from financing opportunities.
Collateral requirements for small business funding largely depend on the specific lender you’re working with. Most traditional lenders, like banks, tend to require collateral, but other lenders, especially online lenders, can be more lenient.
If you’re applying for a Small Business Administration (SBA) loan, you may be asked to provide collateral. However, if you don’t have enough qualifying assets, it’s unlikely you’ll be denied the loan entirely.
For SBA financing, so long as you have strong credit, healthy revenue, and meet the SBA’s size standards, your application should have a good chance of being approved.
There are many different types of SBA loans, so it’s likely a lender can help you find one that suits your needs.
In cases where you are required to put down collateral, you should expect to be allowed to borrow between 60% to 80% of the asset’s appraised value. However, the exact amount may vary depending on the type of asset and the lender.
With equipment financing or real estate loans, the asset you are purchasing typically acts as collateral and you may not have to sign off any personal assets.
Instead of collateral, you may be able to provide a general lien on your business assets or a personal guarantee to secure the loan. In this scenario, your business assets typically won’t need to be valued beforehand – which can make the funding process faster and more straightforward.
Another benefit to providing a general lien or personal guarantee over collateral is that by doing so, you may be able to qualify for even higher funding amounts. That’s because these types of loans aren’t necessarily tied to a loan-to-value ratio of a specific asset the way collateral-backed loans are.
Keep in mind that loans backed by general liens or personal guarantees still carry risk. Just like collateral business loans, you’re jeopardizing your business or personal assets if you default on your payments.
Collateral provides lenders with an extra layer of security, but oftentimes at the borrower’s expense. Collateralized loans can pose additional risks that it’s important to be aware of.
You could risk losing your personal property or business’s property. This could determine your personal finances or even inhibit your business’s production capabilities, especially if you’ve used equipment as collateral.
Nevertheless, some borrowers are willing to put up with these additional risks in exchange for the lower interest rates and higher funding amounts collateralized loans can offer.
Yes, it is possible to secure a business loan without collateral through online lenders or Small Business Administration (SBA). Many businesses will opt for this route to avoid putting their business or personal assets at risk.
That said, securing a business loan without collateral is more difficult. Traditional lenders, like banks, are oftentimes unwilling to approve these types of loans.
Even if you find a bank willing to approve a business loan without collateral, you’ll need to have strong credit and business financials. It’s also likely you’ll have to show you’ve been in business for at least 2 years or more.
Online lenders are more lenient than banks and much more willing to approve business loans without collateral. They also work considerably faster than banks at processing applications.
No matter which type of lender you work with, the interest rates you receive for business loans without collateral will almost always be higher. This is because lenders will compensate themselves for the increased risk on their part.
It helps to compare multiple different financing options to find the best interest rates and terms. In this case, make sure to use National – the top online business financing marketplace.
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Jacinta Sherris is an NYC-based writer and content creator. She holds a BS in Economics from New York University and frequently contributes on a wide range of topics, including finance, entrepreneurship, and small business trends.