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NGExpert financial copywriter
Page written by Chris Godfrey. Last reviewed on September 13, 2024. Next review due October 1, 2025.
You may have heard the term ‘collateral’ before but are unsure what it means or how it works. Essentially, collateral offsets risk when lenders provide a loan. It’s a simple trade-off – you provide assets that lenders can sell if you default on the loan and they provide you with the funds your business needs.
Collateral is an asset or property that a borrower offers to a lender as security for a business loan. If the borrower fails to repay the loan, the lender can seize the collateral to recover the owed amount. By securing the loan with collateral, borrowers may be able to obtain better loan terms, such as lower interest rates or higher loan amounts.
The fundamental goal of any lender is to protect their capital. They want to make money when they provide a loan, but ensuring they get their money back is paramount. Collateral offsets risk and gives the lender confidence that they will get their money back no matter what. This means lenders will typically demand collateral when the borrower’s credit is weak or the loan amount is high. By placing a lien on borrower assets that can be seized and sold to cover the loan amount, the lender’s risk is greatly reduced.
Important note: Not all small business loans require collateral. Some loans, such as vehicle financing or equipment financing, are self-collateralizing, as they use the item you are buying as security for the loan – much like a residential mortgage. Additionally, other small business loans, such as a business credit card, will usually require zero collateral to obtain. However, even where the borrower provides no collateral, they will typically be required to sign a ‘personal guarantee’. This makes them personally liable for the debt, not their business, which means the lender can pursue them and their personal assets, such as their home, if they default on the loan.
Lenders may accept a range of assets as collateral for a loan. Common examples include:
This may be commercial real estate, such as offices, warehouses and factories, or it could be residential property such as houses and condominiums. Where there is already an existing lien on the real estate, such as a mortgage, the lender will only consider the remaining equity in the property, taking a second lien on the real estate as subordinated debt.
Example of using real estate with existing mortgage:
Business equipment can include machinery, heavy plant, production systems, technology and almost anything tangible that businesses use to function. Lenders will always value such assets at fair market value less depreciation – which means wear and tear plus age.
For some businesses, the inventory they hold may be their biggest asset and some lenders will consider this as collateral for a loan. Typically, lenders will value the inventory at cost price, not the higher resale price, less a margin for selling the assets quickly at auction.
Investments can be stocks and share, bonds, treasury bills and other paper assets. These types of collateral are easy to value and liquidate and are considered strong collateral by lenders.
You may wonder why a business with sufficient cash to secure a loan needs a loan. The answer is that for some businesses, it is better to keep the cash on deposit as a balance sheet asset and take out a loan for other purposes than spending their cash on business expenses. Note that only some lenders will consider cash as collateral, but if the funds are in a bank account or deposit account, they will be easy to value and secure.
Invoice financing uses the value of your unpaid invoices as collateral for a loan. You can receive a percentage of the invoice value (up to 95%) within days of raising the bill and then receive any balance (after the lender has deducted interest and fees) when your customers pay the invoice. This loan method means you do not get full value for your invoices, but you get paid in 48 hours or less instead of waiting 30, 60, 90 days or more.
A blanket lien is what is sounds like – the lender places a lien on all your business assets, giving them access to real estate, vehicles, machinery, cash and inventory to repay the debt. This kind of arrangement is more typical for businesses that have few large assets to secure the loan.
Providing collateral to support a business loan may have significant benefits:
But it can also have its disadvantages:
If collateral is required to support your business loan it will typically need to be worth at least the same as the loan amount, plus a margin to allow for legal costs, auction expenses and added interest. This margin is also known as a ‘cushion’ and it can vary according to the level of risk involved in the transaction, the strength of your credit profile and the type of collateral being offered. Generally speaking, more volatile collateral, such as machinery or inventory, will require a higher cushion than more stable collateral such as real estate or investments.
Some business loans do not require collateral, but many do. Popular types of loan where collateral is often needed include:
The most common type of business loan. Term loans are typically used for one-off investments where you know exactly how much cash you need. Commercial real estate purchases, plant and equipment investment, and debt repayment and restructuring activities work well with this kind of loan. You receive a single, lump-sum cash injection and then pay it back in regular instalments, plus interest and any fees, over a fixed period of up to 25 years.
A business line of credit functions like a high-value credit card but comes with lower interest rates and fees. Organizations can withdraw as much as they want when they want from a loan facility up to the limit of their borrowing. Interest rates are usually fixed, and businesses may repay on a set or flexible schedule. This kind of loan is ideal for organizations that want maximum flexibility or for investment situations where the total cash required is unknown.
Standard SBA 7a business loans are provided by banks, credit unions and online lenders who are part of the Small Business Administration (SBA) lender network. Partially backed by the US Government, these loans can provide up to $5million to qualifying borrowers with repayment terms as long as 25 years.
SBA loans usually come with much lower interest rates and fees than other commercial lending but meeting their strict rules of eligibility can be tough for many businesses. As well as an approval process that can take several months, organizations will typically need to have been in business for at least four years and have annual revenues over $180,000. Your personal credit score must be at least 680.
Yes. Even if you don’t have collateral to support a business loan, it may still be possible to give your business the funding it needs. Options include:
These are loans that use the item(s) you are buying to support the borrowing. Use the items as you pay for them while the lender maintains a lien on the assets. Common self-collateralizing business loans include:
Equipment loans use the asset you’re financing as security, similar to a car loan or a residential mortgage. Once the loan is approved, the lender sends the funds to the equipment vendor, who then delivers the machinery. You use the equipment as you pay for it and the lender maintains a lien on the title to the machinery. Once you pay the loan back, the lender releases the lien, and you own the equipment outright. No added collateral required.
Available for businesses that accept customer payments by credit and debit card. A merchant cash advance allows you to borrow against the value of your card sales. As your card sales increase, your borrowing limit goes up. Pay the loan back with a fixed percentage of your card sales on a daily, weekly or monthly basis. Your sales act as security for the loan, no added collateral is required.
Works like a personal credit card but usually comes with higher loan amounts and lower interest rates. Opening a business credit card account and making regular repayments can help borrowers with bad credit improve their score. Added collateral is usually not required.
Available via various online platforms, crowdfunding can bring in large sums if your presentation hits the right spot. Although it’s not easy to raise business financing in small donations from hundreds of donors, this cash is essentially free as there is no interest to pay and you do not need to repay the money if you spend it where you said you would. An eye-catching idea and a powerful pitch is essential to succeed with this funding option. No collateral required.
If you’re seeking outside investment, there are networks of venture capitalists and angel investors readily available online. Bringing in external investment can give you the cash you need, and it may also deliver a unique and extra set of skills and contacts that can help your organization grow even faster.
Note that investors will usually want a piece of the action in exchange for their money. This will mean you giving up a share of your ownership and may loosen your overall control of the business. Some investors may also want higher dividends or royalty payments as well as their share of equity.
No matter if you’re a business owner seeking your first business loan or you’re a seasoned borrower, working with business finance experts can make all the difference when applying for funding. Contact Swoop to discuss your borrowing needs, get help with your application and to compare high-quality business loans from a choice of lenders. Give your organization the financial boost it deserves. Register with Swoop today.
Written by
Chris is a freelance copywriter and content creator. He has been active in the marketing, advertising, and publishing industries for more than twenty-five years. Writing for Wells Fargo Bank, Visa, Experian, Ebay, Flywire, insurers and pension funds, his words have appeared online and in print to inform, entertain and explain the complex world of US consumer and business finance.
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