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Looking for small business financing options can leave the most seasoned entrepreneur overwhelmed. While sorting through loan applications, minimum credit score requirements, repayment terms, and funding schedules, the process can feel very intimidating. Especially when some borrowers are asked to provide collateral or a personal guarantee during the application process to secure the loan. While you don’t have to panic if that happens to you—it’s not an unusual request—it is important to understand the benefits and risks of using collateral to secure a small business loan. In this article, we explore common collateral for business loans as well as the types of loans where it may be required.
What is collateral?
Collateral is defined as an asset pledged by a borrower to secure a loan. Traditional lenders, like banks and credit unions, and some online lenders require collateral to secure certain types of personal loans or business loans. During the loan application process, lenders review a borrower’s creditworthiness to determine their ability to repay borrowed funds. If the borrower is unable to be approved for the loan on credit alone, or is not pleased with the loan offers, securing the loan with collateral, which can be a personal asset or a business asset, minimizes the risks of default for the lender and increases the approval odds for the borrower. The collateral requirements and different types of collateral accepted depend on the lender’s eligibility requirements, the total loan amount, the borrower’s credit history, and the purpose of the funds.
Benefits of using collateral
Using collateral to secure a small business loan can be a great move for entrepreneurs, especially new business owners and those that are not able to meet the lender’s eligibility requirements for annual revenues or credit. Secured loans, also called asset-based loans or ABL, allow business owners to access the funds they need at substantially lower interest rates than unsecured loans. Making on-time monthly payments on a secured loan will also help the borrower improve their business credit history making them better candidates for future financing opportunities.
Risks of using collateral for business financing
The most prominent risk of securing a business loan with collateral is that if the borrower can’t repay the loan, they may lose the asset pledged as collateral. When a borrower pledges collateral as part of the terms of a business loan, the lender takes a lien, or a legal claim against the asset to satisfy the debt. The lien allows the financial institution to seize the asset in the event of borrower default, at which time the asset is sold by the lender, or liquidized, and the proceeds are used to pay off the outstanding debt. If the collateral value is not high enough to cover the balance owed, the borrower will still be responsible for paying off the remaining balance.
Common types of collateral for business loans
Collateral is typically a physical, or tangible asset, but some lenders also allow intangible assets, like patents or copyrights to be used to secure a loan. Small business owners can take out a secured business loan using either personal or business assets, although it is recommended that the two are not commingled.
Business assets used for collateral
Any tangible or intangible asset can be used to secure a loan, if it is approved by the lender. Some business lending options, like equipment loans, use the asset that is being purchased as collateral for the loan. In those cases, the business must repay the debt according to the predetermined repayment schedule before owning the equipment outright. Examples of business collateral include the following:
- Commercial real estate – any land, building, or structure owned by the business
- Cash – a business savings account or cash reserve
- Company equipment or machinery – forklifts, ovens, copiers, computer hardware and software, printing presses, and any other fixed asset owned by the business
- Inventory – retail or wholesale businesses may use purchased inventory to secure new debt or inventory financing
- Investments – stocks, bonds, or other valuable investments
- Future sales – retail or food and beverage businesses can secure capital using future credit card or debit card sales, like with a merchant cash advance
- Commercial vehicles – Cars, trucks, trailers, and vans registered in the company’s name
- Intangible assets – Goodwill, patented technology, copyrights
- Outstanding invoices – unpaid invoices become collateral in invoice financing or factoring agreements
- Blanket liens – instead of securing the debt with specific assets, it allows the lender to seize any and all business assets in the case of default
- Insurance policies – business owner life insurance policies
Personal assets used for collateral
Using a personal asset as collateral on a business loan carries additional risk. If the business is not successful and can not cover its debts, the lender will have the right to seize the personal asset pledged with the loan application. For example, an entrepreneur that uses their family home to secure funds borrowed for business needs risks losing possession of their home and damaging their personal finances if the business defaults on the loan.
- Personal real estate – condos, homes, land, vacation properties, and timeshares
- Home equity – the loan-to-value ratio must meet lender requirements
- Valuables – fine art, jewelry, or other collectibles
- Automobiles – personal vehicles with no outstanding debt
- Cash – personal checking or savings bank account proceeds
- Future paychecks – short-term loans, like payday loans, allow individuals to use unearned pay as collateral
- Investments – investment accounts, like a 401K or IRA
- Life insurance policies – Some lenders allow insurance policies to secure funds
Types of small business loans that require collateral
Most types of small business loans can be either secured, where they require some type of collateral to secure the loan, or unsecured. Secured loans allow borrowers with bad credit or that would not otherwise qualify for funding to get approved, and generally offer better loan terms than unsecured loans.
Commercial real estate loans
CRE loans and business mortgage loans are considered asset-based lending because when a borrower receives a loan to purchase land, buildings, or office space for their business, the loan is secured by the asset that is being purchased. The lender has the right to seize the newly purchased or renovated property if the borrower defaults by placing a lien on the property. Purchasers will not be provided the title for the real estate until the debt is repaid in full.
Merchant cash advance (MCA)
A merchant cash advance is a legal agreement between an entrepreneur and a financial institution or merchant lending company. MCAs work when the borrower receives a cash advance payment and pledges future credit card and debit card revenue as collateral. The lending institution then collects a percentage of sales as repayment. MCAs are a great financing option for retail and restaurant businesses that need to supplement fluctuations in cash flow or cover a one-time expense, like a repair or renovation.
Equipment financing is a small business loan option used to make large purchases, like machinery, business equipment, computer hardware and software, and vehicles. Equipment loans are popular because they allow borrowers to finance 100% of the equipment price. The purchased equipment then becomes the collateral on the debt, so the loan term is the same as the estimated useful life of the asset.
Secured business line of credit
A secured line of credit is a type of financing that works like a business credit card. Once approved, the borrower can access funds within their preapproved credit limit at any time with no second application. When working with an asset-based line of credit collateral is required to secure the credit line and minimize risk for the lender. Typically, asset-based lenders can extend a secured line of credit worth 70 to 90 percent of the asset’s value.
Invoice factoring or invoice financing
Invoice factoring and invoice financing are types of business funding programs where the small business’s accounts receivable balance, or unpaid invoices, become the form of collateral securing repayment. Invoice factoring is when small business owners sell their unpaid invoices to a third-party factoring company, who collects on the invoices and disburses the balance, less fees, back to the small business. Invoice financing is a similar financing option where the borrower receives upfront cash, or a credit line, and the unpaid invoices, to be collected by the borrower, become collateral.
Secured short-term loan
Secured short-term loans are common types of business loans that require collateral. Short-term loans are used by entrepreneurs that need to increase their working capital, make a large purchase, or cover startup costs. The terms for short-term loans are typically 18 months or less and require some type of collateral, like a personal savings account or business asset. Short-term loans have higher interest rates than some long-term financing options but can be a great solution for fast funding.
Small business financing options that do not require collateral
An unsecured business loan is a type of small business financing where the approved borrower is not required to provide collateral. Since there is no collateral required, the approval requirements for unsecured loans typically require that the borrower have a higher personal credit score and good business credit history. In addition to approving applicants based on creditworthiness, lenders often require a personal guarantee when funding unsecured business loans.
SBA Loans are a great financing option for any business. The funds are partially backed by the U.S. Small Business Administration, so SBA loan programs can provide small business owners with lower interest rates and smaller down payments than traditional types of loans. There are multiple SBA loan programs, including the SBA 7(a), Microloans, SBA 504, and disaster loan programs. The maximum loan amount for SBA loans depends on the type of loan and the borrowers’ creditworthiness. Typically funds from SBA loans can be used for large purchases, like equipment financing and commercial real estate, to supplement monthly cash flow, or any other business expenses, like payroll. Some SBA loans require collateral to secure, but unsecured funds are also an option.
Business line of credit
An unsecured business line of credit is a type of revolving credit, like a business credit card. The borrower is approved for a maximum credit limit, and they can then draw on that credit line whenever they need access to fast funding. Lines of credit give borrowers access to fast funds and help the company establish good business credit. The monthly payments include principal and interest, which is calculated on only the amount of funds withdrawn. As the balance is paid down, the borrower has access to the funds again without having to go through the application process again.
Unsecured term loans are a type of small business financing where the borrower receives a lump sum of money upfront and makes regular payments of principal and interest over the term of the loan. Like traditional bank loans, interest rates on may be variable, which change according to the market rate, or fixed, which remain the same over the life of the loan. The repayment terms depend on the lender, amount of loan, and the borrower’s creditworthiness and may reflect a short-term or long-term loan.
Secured loans are a great business financing tool for new business owners, entrepreneurs with bad credit, or any person looking to secure the best possible loan terms. Using any amount of collateral to secure a loan minimizes the risk for lenders, but increases the risks for borrowers that are unable to repay the debt. Funding from loans secured with collateral can be used for any business need including working capital, large purchases, renovations or even to grow the business like these New York franchise owners did with their secured line of credit from Biz2Credit.
If you are considering taking out a secured loan for your business, reach out to Biz2Credit today to hear how they can help you achieve your business goals.