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If you’re looking to grow your business and take it to the next level, collateral can help you do so. But what exactly is collateral? Collateral is a common business loan term that refers to an asset (or item of value) that you promise to a lender when you take out a loan. If you default on the loan by not making payments, the lender can take that asset. If you pay back the loan as promised, then the asset/collateral remains yours.Collateral generally makes lenders more comfortable lending money to you and can often translate into higher loan amounts with lower interest rates. However, not all lenders require a specific type or value of collateral to approve a loan.Read on to learn the pros and cons of using collateral to secure a business loan, as well as what can be used as collateral, and how to get financing even if you don’t have collateral.
What Is Collateral?Traditional lenders, like banks, will often ask what collateral you have as part of the small business loan application process. While secure assets like real estate or equipment are often used as collateral, anything of value the lender can easily sell in order to satisfy your debt should you default might be accepted as collateral.A lender's claim to a borrower's collateral is called a lien — a legal right or claim against an asset to satisfy a debt. The borrower has a compelling reason to repay the loan on time because if they default, they stand to lose the assets they pledged as collateral.
How Collateral WorksBefore a lender processes a loan, it must verify that you have the ability to repay any amount you borrow. Ideally, you’ll do this through regular monthly payments, but what happens if you’re suddenly unable to do so? Does the bank write the loan off as a loss? If you took out a secured loan (which requires collateral), the answer is no. The collateral is liquidated and sold to pay off all or most of the loan balance. Therefore, collateral is used as a form of security for the lender. It guarantees they won’t lose money by lending to you (or at least minimize their losses). The type of collateral you use typically depends on the type of loan you need. For example, if you need the loan to purchase a business vehicle, the vehicle itself will likely be used as collateral. If you need it to purchase an office building, the building itself could be used to secure the loan. In many cases, however, a small business loan isn’t taken out specifically to purchase a hard asset like real estate or equipment. When this is the case, you’ll typically need to use another type of asset, such as equipment, buildings, cash reserves, accounts receivable, or inventory, to secure the loan. Generally, an asset qualifies as collateral if it can be sold by the bank for cash.
What Can and Can’t Be Used as CollateralCollateral is an asset that has value — but not all assets can function as collateral, and some forms of collateral are preferred over others. From a lender’s perspective, the best collateral is an asset that it can liquidate quickly, meaning the asset can be easily converted into cash. Therefore, cash reserves a business has is often favored as collateral. Here are some other things that a business may be able to use to secure a loan.
The only assets that generally don’t qualify as collateral are ones you intend to sell. Once an asset is listed as collateral, part of the debt covenant (rules regarding the loan) will likely be that the asset cannot be sold until the loan is paid off. If your business doesn’t have enough assets to provide the collateral required, a lender might require a business owner to pledge personal assets, such as their car or home, in addition to business assets.
- Accounts receivable (invoices you’ve sent out)
- Home equity
- Future sales
- Real estate
- Certificates of deposit
- Corporate bonds
- Treasury bonds
How Much Collateral is Required for Business Loans?Typically, a borrower should offer collateral that matches the amount they're requesting. However, some lenders may require the collateral's value to be higher than the loan amount, to help reduce their risk.How much collateral you need to provide will typically depend on two things: the “Five C’s” and loan-to-value ratio (LTV) of your collateral.Lenders often use the Five C’s as an indicator of your business’s overall financial health. They stand for:
Different lenders will approach these factors in their own way. For example, if you aren’t able to meet the collateral criteria but have an otherwise qualified application, you may still qualify for the loan.Loan-to-value (LTV) ratio is another key metric lenders use to decide the collateral they need. LTV is the amount a lender will loan you based on the value of the collateral. For example, you may be allowed to borrow 70 percent of the value of the appraised real estate or 60 to 80 percent of ready-to-go inventory. So, if the LTV is 70 percent of the asset you’re putting up as collateral, and that asset is worth $100,000, you would be able to borrow $70,000.Individual lenders consider the LTV ratio differently, so it’s a good idea to ask your lender how they intend to set that value. The following table offers examples of how much collateral may be needed for a business loan.
- Capacity: What is your debt-to-income ratio?
- Capital: How much money do you have?
- Character: What is your credit history? Do you have a history of on-time payments?
- Collateral: Do you have any assets that can act as collateral for the loan?
- Conditions: How much do you need, and what do you need it for? What are the going interest rates right now?
|Type of Loan||Types of Collateral||Loan-to-Value Ratio|
|Invoice Financing||Future earnings||Up to 80%|
|Commercial Real Estate||Property purchased||60% to 90%|
|Equipment Loan||Equipment purchased||Up to 100%|
|General Purpose||Most types of collateral are acceptable||Depends on type of collateral|
|Inventory Loan||Inventory purchased||Up to 50%|
Is Collateral Necessary for Business Loans?No. There are both secured and unsecured loans on the market. An unsecured business loan is a business loan without collateral. For this type of loan, lenders typically look at personal and business credit scores, as well as the business’s overall health, time in operation, and regular cash reserves. It can be a good idea to explore both secured and unsecured loans and compare small business loan rates before deciding what will work best for your business.
Unsecured Business LoansGetting a loan without collateral is often faster because there is less paperwork. However, to qualify, both you and your business will likely need to have a strong credit score. You should also expect the lender to heavily scrutinize all of your finances. There are a few downsides to getting an unsecured business loan. For starters, no matter what your credit score is, it’s unlikely you will get as large a loan without collateral, since collateral tends to make lenders more comfortable lending higher amounts. In addition, your interest rate may be higher. Interest acts as a safeguard to lenders whether you have collateral or not. When you don’t have collateral, however, that interest rate is likely to be higher than it would be if you did have collateral.
If you don’t have any collateral and your credit score could be higher, you may want to look into business loans for bad credit.
|Pros of Unsecured Business Loans||Cons of Unsecured Business Loans|
|Shorter loan application process||Requires strong personal credit score|
|You don't need collateral||Requires strong business credit score|
|You're not putting any of your assets in jeopardy||May require a large amount of cash reserves (not for collateral, but as an indicator of how likely you'll make your payments on time)|
|Lower interest rates||Higher interest rates|
|Higher loan amounts||Smaller loan amounts|
Specific Collateral vs General LiensSome lenders, including many online lenders, don’t require specific collateral, but rather require a general lien on your business assets (without valuing those business assets) and a personal guarantee to secure the loan. This can make qualifying for a loan easier and/or faster, depending upon the nature of your business and your business assets.Borrowers may be more comfortable with specific collateral because they know exactly what they may lose. With a general lien, every aspect of the business is potentially put into jeopardy should there be a default. However, because the loan is not based upon LTV of specific collateral, you might end up qualifying for more than you would with a traditionally collateralized loan.Here’s a look at how these two types of loan compare.
|Multiple assets required?||Better loan terms?||More favorable to the borrower if there is a default?||More favorable to the lender if there is a default?|
The TakeawayCollateral is an asset that a lender accepts as security for a loan. Collateral acts as a form of protection for the lender. That is, if the borrower defaults on their loan payments, the lender can seize the collateral and sell it to recoup some or all of its losses.A lack of sufficient business collateral, however, doesn’t mean you can’t get a small business loan to grow your company (a strategy known as using leverage). Your business may qualify for a general lien on all your business assets collectively, or you may be able to get an unsecured loan, which doesn’t require any collateral.If you’re interested in exploring different types of financing — both with and without collateral — Lantern by SoFi can help. With our online lending platform, you can explore rates from multiple small business lenders with just one application.
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About the Author
Lauren WardLauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.