What Is Collateral?
Collateral can be defined as any asset a lender will accept as security for a loan agreement. When you offer something you or your business owns as collateral, the bank is more likely to give you a loan. If you default, or fail to pay, on a collateralized loan, the bank then has the right to seize that asset.
Financial institutions like offering collateral loans because it gives them a way to recoup their financial losses if you fail to repay the loan. This is beneficial to your business because you’re more likely to get a loan if you have acceptable collateral to put up. The disadvantage is that if you’re not confident in your ability to pay the loan back and you put your house up as collateral, you would be at risk of homelessness if you default on the loan.
A secured loan is any loan backed by collateral, and an unsecured loan isn’t backed by collateral. Unsecured loans are riskier for financiers and usually carry higher interest rates. Secured loans generally have lower interest rates, but they put your provided asset at risk of being seized if you default on the loan.
Acceptable collateral assets
Anything you own with a title is likely an accepted form of loan collateral. Common items include these:
Lenders may have specific guidelines on what they accept for collateral. If you’re in the process of loan shopping, ask lenders about the types of collateral they accept for their secured loans. Some lenders may have distinct collateral-based loans that differ from the traditional secured loan.
Different types of collateral financing
There are several loans that collateralize specific assets in exchange for financing:
- Inventory financing
- Merchant cash advances
- Equipment financing
Each of these financing options deals with business collateral in different ways. Therefore, it’s important to understand how each one works to determine if one of them is right for your business.
Small businesses often experience seasonal fluctuations. Sometimes the busiest sales months come right after low sales periods, leaving you strapped for cash when you need to prepare your inventory for the rush. Some lenders know this and allow businesses to collateralize a loan with the inventory they plan to buy.
The main drawback of this loan is that you’re required to use it to stock up on inventory, making it a pretty inflexible type of financing. But if you need to stock up on inventory, this loan is a great option.
Merchant cash advance
This type of financing allows you to leverage future credit and debit card payments in exchange for financing. The lender gives you a specified amount of financing, and in return you allow them to take a percentage of all your credit and debit card receipts.
The nice thing about this kind of financing is you don’t have to make payments—you pay as your sales come in. Another benefit is that you can use the financing however you want. One major drawback, however, is that the interest rate for a merchant cash advance is higher than average. This type of financing is usually approved quickly, so it’s best used if you're in a pinch.
This type of financing is pretty self-explanatory: you can finance a piece of equipment using the equipment itself as collateral. The equipment secures the loan. And as always, if you default, your lender gets your equipment.
How collateral loans work
If you want something collateralized, it first has to be appraised by an independent professional. Once an appraiser has determined the value of your asset and given the quote to your lender, you’ll be offered a loan amount according to the lender’s loan-to-value ratio.
The loan-to-value ratio is the total loaned amount divided by the total appraised value of the asset. For example, if your car is valued at $10,000 and the lender gives you an $8,000 business loan, your loan-to-value ratio is 80%.
This ratio is determined by the lender based on what they expect to sell your asset for if they have to seize it from you. Most banks sell their acquired assets at a reduced rate as part of a fire sale because they don’t want to hold onto them.
Collateral vs. business credit scores
When a financial institution assesses a borrower for a collateral loan, they look at their business credit score. If your credit score isn’t looking too good, a good collateral offering can improve your chances of getting a loan, but it doesn’t guarantee you’ll get an offer.
We can’t emphasize enough how careful you should be when offering any belonging or property as collateral. Be sure you have a clear plan for making your monthly payments so you never default.
Here’s the bottom line: be smart and careful. Consider using alternative forms of collateral financing like equipment financing or inventory financing with a clear path for repayment and profit. But whatever you do, be sure to read the fine print so you know exactly what you’re getting into.
If you need help finding the perfect loan for your business, check out our rankings of Best Small Business Loans of 2022. We’ve dug up all the details you need to make an informed choice
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