Business loans come in two forms – unsecured and secured. Unsecured loans do not require any form of collateral offering, which makes them riskier to the lender. A riskier loan for the lender always results in a higher interest rate for the borrower. Secured loans, on the other hand, come with collateral requirements, and the amount and type of collateral you’ll have to put up varies by the type of loan you select. This increases the borrower’s risk but also results in a lower interest rate. Borrowers who use collateral can typically command higher loan amounts.
What is Commercial Lending Collateral?
Commercial lending collateral describes any asset(s) that you put up as security when taking out a business loan. The assets provide an added layer of protection for the lender since they can recoup them if you fall behind on the loan payments to minimize financial losses. Lenders usually provide lower interest rates for loans with collateral since risk shifts to the buyer.
Usual Types of Collateral for Business Loans
The collateral requirements for business loans vary by the type of financing you select. Here are examples of common types of collateral you may need for a loan.
Real Estate
Real estate collateral is commonly used to secure business loans.
More often than not, it’s worth a sizable sum of money, which is why lenders accept this form of collateral. Every mortgage uses real estate as collateral, but you can also take out a line of credit on a property you already own. In this case, the property once again becomes collateral. It’s possible to pay a mortgage and line of credit tied to your property at the same time.
But, as a business owner, there’s a major drawback to using real estate as collateral – you could lose your property if you default on the loan agreement. This could be problematic if the only type of real estate you have at your disposal is the home you currently live in. Losing commercial real estate can also disrupt foot traffic. Business owners may lose customers if they have to relocate, especially if they move to another town. A 10-minute drive can suddenly become an hour-long drive. That can be enough to scare away your most loyal customers, so proceed with caution before offering real estate as collateral to get business funding.
Business Equipment
Business loans with equipment collateral are another popular choice that many lenders accept. However, keep in mind that you may not be able to access as much capital as you need due to the depreciation of your equipment’s value. Furthermore, the lender may be reluctant to accept the equipment because of the challenges associated with selling the asset if you fall behind on payments. Equipment is less liquid, and its value will decrease each year as it becomes older and better alternatives get released.
Inventory/Stock
If you have inventory or stock on hand, you may be able to use it as collateral. But, like business equipment, lenders might not accept it if the merchandise is difficult to resell. You should also consider the risk you’ll assume by putting it up for collateral if you fall on hard times, particularly if it’s the lifeblood of your business.
Invoices
You can sell the rights to your future invoices in exchange for cash in the short term. The upside is you can keep operations afloat. Still, there’s also a significant disadvantage – you’ll generally pay a hefty sum of interest or fees, which means you’ll technically make less money on the sale of those goods or services. Nevertheless, invoice factoring is one of the few ways to raise capital without getting into debt. You don’t have to worry about making monthly payments, but you won’t have as much incoming revenue since you sold the invoices.
You should only work with a reputable invoice factoring company that won’t haggle your clients. Invoice factoring companies take the responsibility of collecting payments. While delegating this opportunity can save you time, a long-time client may not want to do business with you if the invoice factoring company asks them repeatedly about making the payments.
Cash
Using cash as collateral can unlock competitive financing opportunities for your business. Still, you risk losing a sizable portion of your reserves immediately if you fail to repay what you owe.
Blanket Lien
As the name implies, blanket liens cover all of your company’s assets. Consequently, this form of collateral should only be used as a last resort, as you risk losing your entire company if you fall behind on payments. Lenders only request blanket liens for riskier customers. If you have good credit and demonstrate the ability to repay loans, banks won’t request blanket liens.
Investments
Stocks, bonds, and other investments in your portfolio are another form of collateral lenders will accept when seeking a business loan. But, if they’re a part of your nest egg, it probably isn’t a good idea to put investments you own up for collateral.
The way you get financing from this strategy also has some risks. Margin loans let small business owners and consumers borrow against their portfolios, but if your portfolio falls below a certain level, the brokerage firm can initiate a margin call. During a margin call, a brokerage firm can sell a certain percentage of shares without asking for your permission to reach an acceptable level of liquidity. These sales can trigger capital gains, as a brokerage firm won’t prioritize asset sales based on which investments have capital gains or losses. You can get around this issue by borrowing a small amount of margin instead of borrowing $1 of margin for every $1 in your portfolio.
Small business owners using margin loans shouldn’t be tempted to use available margins to grow their portfolios in an effort to play catch up. Margin loans are risky financial instruments and can provide the financing you need to address cash flow concerns and long-term business investments, but you shouldn’t make yourself vulnerable to a margin call.
Should You Secure a Loan with a Collateral?
It varies by the business owner and the number of assets they have available to use as collateral. If you can put up a sizable amount to secure a loan, it may be worthwhile if the offering will help you qualify for a higher loan amount or better loan terms. Alternatively, if you have little to no assets at your disposal to put up for collateral, a secured loan likely won’t make sense for your business. However, you can still get respectable loan terms with an unsecured business loan. Business credit cards are a great source of financing that does not require collateral and can help address short-term cash flow gaps.
For some people, a business loan with collateral is the only option. Financial institutions may feel more comfortable working with startups and businesses with bad credit if they use business assets as collateral. Some lenders may even ask you to make a personal guarantee on your loan, which lets the borrower use personal assets as collateral.
Unsecured business loans usually go to companies that have more experience, good credit scores, and a pristine payment history. When you put up collateral, you will lower your interest rate on the loan, but business owners must assess their ability to repay the loan before taking that risk.
If repayment is the concern, you could add more years to the back of your loan to lower monthly payments or request less capital from lenders. Of course, you can always borrow more money later if necessary, especially if you take out a line of credit with a high credit limit.
How Much Collateral Do Lenders Usually Require?
Again, it depends on the type of loan you select. Lenders will also analyze your company’s financial health, credit history, and number of years in business to decide on the amount of collateral you’re required to put up to get a secured loan. The lender wants to see if you can reliably make loan payments, and each lender has different requirements.
You may have to put up more collateral if you get a loan from traditional lenders or credit unions. These companies have higher requirements and usually take longer to provide borrowers with the financing they need. Loans from the U.S. Small Business Administration do not have any collateral requirements, but they also have high credit score requirements and are harder to obtain. Online lenders have more flexibility and may not request any collateral in some cases. You can also receive funding a lot faster if you go this route.
How to Know Which Type of Collateral Works Best for You
The ideal type of collateral to secure a business loan depends on the assets the business owner has available. Some small business owners have enough real estate properties to comfortably use one of them as collateral. Other small business owners may prefer using equipment as collateral because they don’t want to risk losing their real estate.
You may also prefer to avoid debt. Small business owners who want to avoid monthly loan payments and have several unpaid invoices can use invoice factoring. This solution provides upfront cash that you can use to cover expenses, and you won’t have to worry about a loan’s monthly payments restricting your cash flow.
It’s equally vital to assess if you can afford to put them up for collateral without risking your company’s financial health. Is it detrimental to your business if you lose the collateral, or is it easy for your company to bounce back? If you feel jittery about the loan, you may want to request a smaller loan amount or wait until you strengthen your finances, but financial conditions can change for any robust business. You should also think carefully about using a personal guarantee to provide financing for a sinking ship. The LLC separation from personal finances is a valuable advantage for many business owners. Piercing the corporate bubble is risky as it is, especially for a company on life support.
