Everything You Need to Know About Collateral For A Business Loan

What is collateral?

Collateral is an asset, such as cash or real estate, that a loan applicant offers to secure a loan as a guarantee that the loan will be repaid. The applicant agrees that the lender can claim ownership of the collateral if the applicant defaults on the loan.

The lender gains ownership of your collateral if you default on payment, whether you pledge your car, house, or equipment. Since it gives the lender peace of mind, collateral can allow people with less-than-stellar credit to qualify for a small business loan.

Lenders want to lend money to people who have skin in the game for pretty obvious reasons—they want some way to get their money back in case you stop repaying your loan. Commonly, banks want small business loans to be fully collateralized, meaning you need to offer enough collateral to cover 100% of the proposed loan amount.

What qualifies as collateral?

Different types of lenders accept various forms of collateral, so there are several routes you can take. It’s important to remember that there’s always a risk that you’ll lose the collateral if you default on your loan.

Cash

Collateral in the form of cash, as a deposit or in savings, will always be the gold standard for banks. It’s low risk for banks because it’s very easy to get their money back in case you default. While you’ll get the most favorable terms if you offer cash as collateral, you might want to shield your money from banks. Although it’s important to note that, as long as it’s being used as collateral, you also won’t be able to touch the cash.

Real estate and home equity

Real estate and home equity are the most commonly offered collateral for small businesses because a house is typically the most valuable asset an individual possesses. However, most banks will only take a small fraction of equity accrued on a house as collateral because they follow stringent debt-to-income ratios.

Automobiles

Along with homes, cars are common options for collateral. It’s best if you own your vehicle or if the total amount you owe on your car note is significantly less than its Kelley Blue Book value. Often, credit unions will offer loans for close to 100% of the value of your car. However, before offering your car as collateral, you should check with your lender to ensure that the terms of the small business loan you’re seeking will allow this.

Commercial properties and equipment

Like residential real estate, you can use commercial property as collateral. If you plan to buy commercial property with a loan, you can actually use the property in question as collateral. However, banks tend to lend less against commercial property since it is considered a less secure investment than residential property. Banks usually lend up to 50% of the value of commercial property. The same sort of financing is also available for expensive equipment.

Inventory

Product-based businesses commonly use unsold inventory as collateral. Keep in mind that your lender may value your inventory differently than you do. If you choose to take this route, remember to periodically provide updated inventory lists to your lender to ensure that your loan is properly collateralized.

401(k)

You can leverage your 401(k) as collateral, but you might get hit with a large tax bill. Many 401(k) plans allow you to take a loan out at prime interest plus one to two points. Other investments can be used as collateral, but you will typically get worse rates than if you had offered cash.

Another way you can use your 401(k) to finance a business is to execute a Rollover as Business Startups (ROBS). It’s an arrangement that lets you access your funds without incurring taxes, penalties, or interest charges, even if you have bad credit.

A ROBS involves forming a C corporation and starting a retirement plan for the business entity, then rolling over the funds from your old 401(k) into the new account. That allows you to purchase stock in your own company with the rolled-over funds and use the proceeds from the sale to fund your business.

While it can be effective, a ROBS is a highly complex and risky strategy that can cost you your business and retirement funds. It should generally be a last resort, and you should always consult a tax professional before attempting one.

Accounts receivable and purchase orders

Some lenders have options called asset-based loans that accept a small business’ inventory and accounts receivable as collateral. These loans will typically be smaller than when other assets are offered as collateral because it’s difficult for banks to determine the value of your inventory or accounts receivable. However, these can be good options if you don’t have a lot of valuable assets like real estate.

Credit card transactions and deposits

As a small business, you can apply for merchant cash advances, where you trade a portion of your daily credit card sales for a lump sum loan. There is no personal guarantee with this type of payment: it applies to your company only, and it will not affect your personal credit score if, for some reason, you cannot repay the loan. While merchant cash advances are flexible, the interest rates are often high.

How much collateral will you need?

Before applying for any loans, think hard about the size of the loan your business requires and what you’re willing to put up as collateral. Traditional banks want their loans to be fully collateralized, but other lenders might be less strict. In those cases, though, the interest rates will usually be higher, and the loan amounts will be smaller.

The amount of collateral required for a small business loan can vary widely, based on several factors. This includes the type of loan, your credit history, and the lender’s policies. Typically, lenders may want the collateral to match or exceed the value of the loan. However, it’s important to bear in mind that some lenders could require collateral worth up to 150% of the loan amount due to the inherent riskiness in business ventures. 

Always ensure that you have a comprehensive understanding of your lender’s collateral requirements before agreeing to a loan. Remember, the collateral serves as a safety net for the lender, but it could mean a significant loss to your business if you’re unable to pay back the loan.

Don’t be afraid to negotiate with a lender based on alternative lending options, your credit history, and the value of your assets.

Pros and cons of collateral loans

Like any business decision, using your assets as collateral comes with its own set of advantages and disadvantages.

Pros

1. Access to larger loans – Lenders are more likely to offer larger loan amounts if they know there’s collateral backing the loan.
2. Lower interest rates – Loans secured with collateral typically come with lower interest rates because there’s less risk for the lender.
3. Improved loan terms – Collateral-based loans often come with more favorable terms, such as longer repayment periods.

Cons

1. Risk of loss – The most significant downside to using collateral is the risk of losing your assets. If you’re unable to repay the loan, the lender can take possession of your collateral.
2. Reduces liquidity – Once you pledge an asset as collateral, you can’t sell it or use it as collateral for another loan until you’ve repaid the initial loan.
3. Valuation disputes – Sometimes, there can be disagreements about the value of the collateral, which could affect the loan amount or terms.

It’s essential to weigh these pros and cons carefully before deciding to use your assets as collateral for a business loan. If you’re unsure, consider seeking advice from a trusted financial advisor.

What if you don’t have collateral?

If you’re like many Americans without valuable assets—or just don’t want to risk putting anything on the line—there are other alternative lending options:

1. Unsecured business loans – These loans are issued based purely on your creditworthiness and do not require collateral. However, they typically come with higher interest rates, due to the increased risk to the lender.
2. Business credit cards – Another option is to consider a business credit card. While not a traditional loan, these cards can provide the capital needed for purchases or emergency expenses.
3. Merchant cash advances – This is an advance against your business’ future income. The provider gives you a lump sum, which you then repay via a percentage of your daily credit and debit card sales.
4. Invoice financing – If your business has unpaid customer invoices, some lenders will provide a cash advance based on their value.
5. Crowdfunding – Crowdfunding platforms allow businesses to raise small amounts of money from a large number of people. This isn’t a loan, so you don’t have to repay the funds, but you may need to provide some type of reward to your backers.

Each of these options has its pros and cons, so it’s important to carefully consider your business’ needs and financial situation before deciding.

Collateral serves as a safety net for lenders, giving them something to fall back on if a borrower defaults on their loan. While the idea of putting your assets on the line can be daunting, it can also open doors to larger loan amounts, lower interest rates, and improved loan terms. The key is to thoroughly understand your business’ financial needs, the risks involved, and the value of your potential collateral.