There is a lot to consider when you start a business, and one of the most important parts is getting finances in order. If you don’t already have money at your disposal, you may have to take out a business loan to get started or give you more money to work with. However, this may come with some questions about secured and unsecured loans and what collateral means in terms of business loans. Collateral can make or break your ability to receive a loan, so it’s important to understand what you’re getting into.
What is Business Loan Collateral?
Collateral is the use of your business or personal assets as further security for the lender. If you are unable to pay back your loan, the lender can seize these assets and sell them to pay off the balance of the loan. Typically, assets will need to be fully owned by you or funded by finances from the loan itself. Most small to mid-size business loans will require some sort of collateral in order for the loan to be approved and fulfilled.
While that may sound confusing, think of it in terms of financing a car. When you’re making car payments, that vehicle is not owned by you legally. Technically it is the property of the lender that purchased it, though it is in your possession. Financing a car is typically a low-risk situation for lenders because the vehicle itself is used as collateral, and the lending agent can repossess the vehicle if you default on your payments.
Similarly, business assets that you purchase using the funds provided by the lender can be considered collateral and can be seized if you are unable to pay the loan back.
In some cases, this type of collateral is all that you need, but other times you might need to use a combination of a few different things depending on the requirements of the loan and the amount you’re looking to finance.
What Can Be Used As Collateral?
Collateral can come in many different forms. Some of them are likely to be funded through the loan, yet others can be property or assets that you already have. Let’s investigate some common forms of collateral for business loans.
Real Estate
Real estate is a popular choice for business loan collateral. If a business owner owns any buildings or rental property, these can be used as collateral to secure a loan. Sometimes a business owner will even put their own home on the line. However, this can be a very risky choice to make, especially in the case of small to mid-size businesses. Most homeowners don’t necessarily have another house to fall back on. If you feel like this is an undue risk, then you might want to consider some of the other collateral options.
Vehicles
Typically, when you use vehicles as collateral they will be fleet vehicles owned by your business, and if you purchase vehicles with money from the loan they will automatically count toward your collateral. However, you can also use any valuable personal vehicles that you may have as part of your collateral, though some people find this to be an unnecessary risk.
Equipment
Any equipment purchased with funds from the loan is typically considered to be part of the collateral, but if you’re funding any equipment yourself, you can absolutely include this as part of your collateral. Equipment can be anything from manufacturing equipment to office supplies. As long as the lender estimates little change in value over time, you can use it as collateral.
Receivables
Receivables are outstanding payments from customers. Anything less than 90 days old can typically be used as collateral. In fact, this is almost as good as using cash to pay back a loan as long as your lender approves it.
Savings
If you have a business savings account, that’s a great option for business loan collateral. Nothing is better than using cash because cash won’t depreciate in value, plus many savings accounts grow over time. However, be wary of using your personal savings account as collateral, as that can put you in an unfortunate financial situation should your business fail to thrive.
Inventory
If you’re selling products at your business that have been funded through your loan, these will automatically be used as collateral in most cases.
Investments
Personal investments such as stocks or bonds can be used as collateral in many cases.
Personal Guarantee
A personal guarantee is often not considered to be a type of collateral, but it is important to mention it as it will likely come up when you do your research.
A personal guarantee is an agreement between you and your lender that you will use your personal assets to pay off the rest of the loan should your current collateral or lack thereof not be enough to cover the cost of the loan.
Often, a personal guarantee is used in conjunction with collateral to ensure that all bases are covered and that there is enough money available that the lender will consider your loan to be a reasonable risk. Other times, a personal guarantee is used instead of collateral. When this happens, the loan is considered to be an “unsecured” loan which can be very hard to get, as it creates a lot of risk on both sides of the equation.
How Much Collateral Do You Need?
The short answer is that it depends on the loan. Consider the size of the loan you’re asking for. A small business asking for a $10,000 loan may only need to use a vehicle as collateral. But let’s say the business owner is asking for $50,000. In this case, you might need to use more than one type of collateral to secure the loan or use a personal guarantee.
A good rule of thumb is to ensure that the assets you’re using as collateral together are valued at about 25% more than the loan you’re requesting because most lenders will not lend you any more than 80% of the appraised value of the collateral assets.
If your suggested collateral isn’t enough to cover what you’re asking for, there are a couple of things that you can do:
- Request a smaller loan
- Secure another piece of collateral
- Provide a down payment
- Use a personal guarantee
Not All Collateral is Created Equally
One reason it’s important to have more collateral than the total cost of the loan is that not all collateral is equal or will be viewed as valuable to the lender. While a property you own may be valued at $150,000 technically, it doesn’t mean that a lender will necessarily be willing to give you a $150,000 loan based on that collateral.
If worse comes to worse, the lender getting their money back involves the lengthy process of selling the property and potentially having to accept a payment of less than the property is technically worth. While business loan collateral abates some of the risk of lending, it can still be unpredictable, so oftentimes lenders will shave a little bit of money off the top to ensure they don’t lose money on your loan.
If you’re not sure what to expect or want to have a more concrete answer to how much you can finance for your business, it wouldn’t hurt to ask a few different lenders about it, because chances are, you’ll get several different answers.
Is Collateral Necessary?
In many cases, collateral is required to secure a business loan. Using collateral protects you and your personal assets, as well as increasing the chances of a lender approving your business loan.
If your credit score is less than favorable, or if you don’t have much history of paying back loans, it would be hard to qualify for a loan in general, so having collateral at stake gives you the chance to receive a loan that might have been nearly impossible otherwise.
However, there are what are known as “unsecured loans” available which do not require collateral, but it’s important to read the fine print and know what you’re signing up for.
For example, a lender may claim that collateral is not required for a loan, yet still require a personal guarantee, which puts you and your personal finances at a higher risk. Plus, unsecured loans are likely to have high interest rates, making it that much harder to pay them off in the long run.
If using collateral truly isn’t an option for you, don’t despair. If you have a good credit score, no bankruptcies on record, and a thriving business, you have a decent shot of being able to obtain an unsecured business loan.
Get a Business Loan: Collateral or No Collateral
Starting a business is hard work, but getting approved for a business loan shouldn’t have to be. At BusinessLoans.com we have a streamlined process to match business owners with lenders so you can focus on the ins and outs of your business. We specialize in helping small and mid-sized businesses reach their full potential through business loans. Collateral or no collateral, we’ll find a lender that works for you. Start the application process today!
