The ebb and flow of modern business is difficult to predict. Small businesses, in particular, can struggle to react to fast-changing market conditions. There may be times when short-term cash injections are needed to cover temporary cash flow problems or capitalize on opportunities for expansion. And at times like these, collateral loans can be useful financing options.
Whether you need funds to expand your business or simply cover a temporary cash shortage, collateral loans could be the answer. To ensure you choose the right product, you need to know exactly what you’re dealing with.
Collateral loans, defined
Collateral is an asset used by a lender as security for a loan. While there are unsecured loans available, collateral loans tend to offer lower rates thanks to the reduced risk the lender faces. If you default on the loan, the lender can seek to recoup losses from the collateral.
Many traditional lenders require at least one asset as collateral. This might be property (such as pieces of equipment), shares in a business, future profits, or unpaid invoices. How much collateral is needed depends on a range of factors, including the loan amount, term, purpose of the loan, and business’s credit history.
Does a collateral business loan make sense for me?
Applying for a collateral business loan makes sense if your business is viable over the long-term. If you’re borrowing money against assets in order to delay the inevitable, a collateral loan might not be the best answer for your business. But if your business has strong assets and a demonstrably bright future, a loan secured with collateral could be the right choice.
If you have collateral, you may also enjoy higher loan amounts, longer repayment terms, and lower interest rates.
What type of collateral is required for secured collateral loans?
When you take out a collateral loan, you’re making a legal commitment to repay it according to the agreed schedule. If you fall seriously behind with your repayments, the lender can sell off your secured assets to recoup the outstanding balance on the loan.
As long as your collateral has significant value, there’s a chance your loan provider will consider it for a secured loan. The most common forms of collateral are:
- Real estate: You may be able to use commercial property to secure your loan. Some lenders will also lend against the equity your business holds in a property (the difference between your real estate loan balance and the property’s current market value).
- Cash: You may be able to secure a collateral loan with a business bank account. Lenders have the option of liquidating the business bank account if you fail to stick to the payment plan. Because this type of loan can reduce the risk to the lender, you may find favorable terms.
- Equipment: If your business owns equipment with significant resale value, your lender may accept it as collateral. In many cases, high-value equipment (such as factory-based machinery) secures favorable rates and longer repayment schedules.
- Inventory items: If your business keeps an inventory of stock, you might be able to use it as collateral. However, your inventory needs to be of reasonably high value.
- Invoices: If you run a business that holds a lot of unpaid invoices, you may be able to use them as collateral. An unpaid invoice represents future income. If you fail to repay your loan, however, the lender will collect the monies owed when the secured invoices are paid.
- Blanket liens: This type of collateral loan gives the lender the opportunity to use all viable assets owned by a business as collateral.
- A personal guarantee: A personal guarantee gives your lender the right to seize any personal assets you personally own now or in the future in order to satisfy the outstanding business debt.
What if I don’t own any collateral?
If you don’t have any business assets to secure a loan, you might be eligible for unsecured financing. However, as the risk to the lender is greater, expect potentially less favorable rates and repayment terms. The loan amounts available tend to be smaller, typically below $25,000. You’ll need to prove your business income and present a plan for how the funds will be spent. Your business’s credit history and age will be determining factors in the lender’s decision.
Can I avoid adding collateral to my loan?
The simple answer is yes, but it’s not always easy. Essentially, you’re asking for a loan based on little more than goodwill. You’ll need to demonstrate a long history of sound financial management. You’ll also need to have a strong credit rating. The lender is likely to ask for bank statements, accounts records, and a comprehensive business plan that details how you will spend the funds. But beware: Unsecured loans can come with higher rates.
What happens with the collateral if I do not make payments on time?
Your lender will probably seek to sell your secured assets in order to offset the outstanding balance your business owes. How and when this will happen should be detailed in your loan agreement. However, this is usually a time-consuming process that involves a range of costs. Most lenders will only seek to sell assets used as collateral if they’ve exhausted all the alternatives, including adjusted repayment plans, extra time to pay or filing a lawsuit.
I need a small business loan, but I don’t want a collateral loan. What options do I have?
If your business is in good standing, you might be eligible for an unsecured small business loan or an unsecured line of credit. However, expect to potentially pay a higher rate than you would with a collateral loan.
Small business financing that may require collateral
There are several types of collateral business loans that may be available to you:
SBA loans: A Small Business Administration (SBA) loan is partially guaranteed by the U.S. government. You and your business will need a high credit score to be eligible.
Asset-based loans: Asset-based loans are secured with assets such as inventory, equipment, and accounts receivable.
Lines of credit: A line of credit is a flexible business finance product that provides you with working capital. You draw against the approved working capital when you need it. This is a good way of controlling costs, as you only use-;and pay for-;the credit you need.
Commercial real estate: A commercial real estate loan is used to purchase or develop buildings, land, and various other forms of commercial property. Your business can leverage existing equity to secure the finance required for expansion.
Pros and cons of collateral loans
There’s always a risk involved when borrowing money. It’s important to assess risks fully before committing to a collateral loan.
A loan secured against assets may have a lower interest rate than an unsecured loan, as the risk to the lender is mitigated. That reduced risk may also mean that lenders can provide larger loans and better terms. And collateral loans for bad credit help businesses to rebuild their credit rating, reducing the cost of finance in the future.
But a collateral loan may be a risk you’re not willing to take. Just remember: if you fall behind with your repayments, you could lose the assets secured against the loan.