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Collateral refers to an asset or item of value that you promise to a lender when you take out a loan. If you default on the loan by not making payments, the lender can take that asset. If you pay back the loan as promised, then the asset/collateral remains yours.
Collateral generally makes lenders more comfortable lending money to you, which can often translate into higher loan amounts with lower interest rates. However, not all lenders require a specific type or value of collateral to approve a loan.
Read on to learn the pros and cons of using collateral to secure a business loan, what can be used as collateral, and how to get financing if you don’t have collateral.
Key Points
• Collateral is an item of value used to secure a loan with a lender.
• Many types of assets can be used as collateral; lenders prefer those that can be quickly liquidated into cash.
• Loan approval depends on the five Cs (capacity, capital, character, collateral, and conditions) and loan-to-value (LTV).
• Collateral is not always required for business loans. There are both secured and unsecured loans on the market.
• Some lenders, including many online lenders, require a general lien on your business assets and a personal guarantee to secure the loan, instead of specific collateral.
What Is Collateral?
Collateral is an item of value that you use to secure a loan with a lender. Traditional lenders, such as banks, will often ask what collateral you have as part of the small business loan application process.
While secure assets, such as real estate or equipment, are often used as collateral, anything of value that the lender can easily sell to pay off your debt should you default might be accepted as collateral.
A lender’s claim to a borrower’s collateral is called a lien — a legal right or claim against an asset to satisfy a debt. The borrower has a compelling reason to repay the loan on time because if they default, they will lose the assets they pledged as collateral.
How Collateral Works
Before a lender processes a loan, they must verify that you can repay the amount you borrow. Ideally, you’ll do this through regular monthly payments, but what happens if you’re suddenly unable to do so?
Does the bank write the loan off as a loss? If you took out a secured loan (which requires collateral), the answer is no. The collateral is liquidated and sold to pay off all or most of the loan balance. Therefore, collateral is used as a form of security for the lender. It guarantees they won’t lose money by lending to you (or at least it minimizes their losses).
The type of collateral you use typically depends on the type of loan you need. For example, if you need the loan to purchase a business vehicle, the vehicle itself will likely be used as collateral. If you need it to purchase an office building through a commercial equity line of credit, the building itself could be used to secure the loan.
In many cases, however, a small business loan isn’t taken out specifically to purchase a hard asset such as real estate or equipment. When this is the case, you’ll typically need to use another type of asset, such as equipment, buildings, cash reserves, accounts receivable, or inventory, to secure the loan. Generally, an asset qualifies as collateral if it can be sold by the bank for cash.
What Can and Can’t Be Used as Collateral
Collateral is an asset that has value — but not all assets can function as collateral, and some forms of collateral are preferred over others.
From a lender’s perspective, the optimal collateral is an asset that it can liquidate quickly, meaning the asset can be easily converted into cash. Therefore, a business’s cash reserves are often preferred as collateral.
Here are some other things that a business may be able to use to secure a loan:
• Accounts receivable (invoices you’ve sent out)
• Buildings
• Equipment
• Home equity
• Future sales
• Inventory
• Real estate
• Securities
• Certificates of deposit
• Corporate bonds
• Stocks
• Treasury bonds
• Vehicles
Not all items qualify as collateral, such as perishable goods and leased equipment. Once an asset is listed as collateral, part of the debt covenant (rules regarding the loan) will likely be that the asset cannot be sold until the loan is paid off.
If your business doesn’t have enough assets to serve as collateral, a lender might require the business owner to pledge personal assets, such as their car or home, in addition to business assets.
How Much Collateral Is Required for Business Loans?
Typically, the value of the borrower’s collateral should match the loan amount they’re requesting.
However, some lenders may require the collateral’s value to be higher than the loan amount to help reduce their risk.
How much collateral you need to provide will typically depend on two things: the five Cs and the loan-to-value ratio of your collateral.
Lenders often use the five Cs as an indicator of your business’s overall financial health. They stand for:
• Capacity: What is your debt-to-income ratio?
• Capital: How much money do you have?
• Character: What is your credit history? Do you have a history of on-time payments?
• Collateral: Do you have any assets that can act as collateral for the loan?
• Conditions: How much do you need, and what do you need it for? What are the current interest rates?
Different lenders may approach these factors differently. For example, if you aren’t able to meet the collateral criteria but have a qualified application, you may still qualify for the loan.
The LTV ratio is another key metric that lenders use to decide the collateral they need. LTV is the amount a lender will loan you based on the value of the collateral. For example, you may be allowed to borrow 70% of the value of the appraised real estate or 60% to 80% of ready-to-go inventory.
So, if the LTV is 70% of the asset you’re putting up as collateral, and that asset is worth $100,000, you can borrow $70,000.
Individual lenders apply different LTV ratios, so it’s a good idea to ask your lender how they intend to set that value. The following table offers examples of how much collateral may be needed for a business loan.
| Type of Loan | Types of Collateral | LTV Ratio |
|---|---|---|
| Invoice financing | Future earnings | Up to 100% |
| Commercial real estate | Property purchased | Up to 75% |
| Equipment loan | Equipment purchased | Up to 80% |
| General purpose | Most types of collateral are acceptable | Depends on the type of collateral |
| Inventory loan | Inventory purchased | 50% to 80% |
Is Collateral Necessary for Business Loans?
No, collateral is not necessary for business loans. There are both secured and unsecured loans on the market. An unsecured business loan is a business loan without collateral.
With unsecured business loans, lenders typically look at personal and business credit scores, as well as the business’s overall health, time in operation, and regular cash reserves. It can be a good idea to explore both secured and unsecured loans and compare small business loan rates before deciding what will work best for your business. You may also consider a stated income business loan for a process with less documentation required.
Unsecured Business Loans
Getting a loan without collateral is often faster because there is less paperwork. However, to qualify, both you and your business will likely need to have a strong credit score. You should also expect the lender to heavily scrutinize all of your finances.
There are a few downsides to getting an unsecured business loan. For starters, no matter what your credit score is, it’s unlikely you will get as large a loan without collateral, since collateral tends to make lenders more comfortable lending higher amounts.
In addition, your interest rate may be higher. Interest acts as a safeguard to lenders, whether you have collateral or not. When you don’t have collateral, however, that interest rate is likely to be higher than it would be if you did have collateral.
| Pros of Unsecured Business Loans | Cons of Unsecured Business Loans |
|---|---|
| Shorter loan application process | May require longer approval and funding |
| No collateral needed | Strict eligibility requirements |
| No need to put your assets in jeopardy | May require a personal guarantee |
| Loan may be discharged in bankruptcy | Higher interest rates |
If you don’t have any collateral and your credit score could be higher, you may want to look into business loans for bad credit.
Specific Collateral vs General Liens
Some lenders, including many online lenders, don’t require specific collateral but a general lien on your business assets (without valuing those business assets) and a personal guarantee to secure the loan.
This can make qualifying for a loan easier and/or faster, depending upon the nature of your business and your business assets.
Borrowers may be more comfortable with specific collateral because they know exactly what they may lose. With a general lien, every aspect of the business is potentially put into jeopardy should there be a default.
However, because the loan is not based on the LTV of specific collateral, you might end up qualifying for more than you would with a traditionally collateralized loan.
Recommended: Guide to Typical Small Business Loan Requirements
The Takeaway
Collateral is an asset that a lender accepts as security for a loan, acting as a form of protection for the lender. If the borrower defaults on their loan payments, the lender can seize the collateral and sell it to recoup some or all of its losses.
A lack of sufficient business collateral, however, doesn’t mean you can’t get a small business loan to grow your company (a strategy known as using leverage). Your business may qualify for a general lien on all your business assets collectively, or you may be able to get an unsecured loan, which doesn’t require any collateral.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What types of collateral do startup businesses use?
Due to their limited operating history, lenders often look for assets with clear, verifiable value that can be easily liquidated if the startup defaults. Common examples include cash or cash equivalents (e.g., deposit accounts), marketable securities (publicly traded stocks or bonds), and real estate.
What is the difference between secured and unsecured loans?
Secured loans are backed by collateral, while unsecured loans are not, resulting in higher risk and interest rates. However, getting a loan without collateral is often faster because there is less paperwork involved.
Why do secured loans tend to have lower interest rates?
Secured loans tend to have lower interest rates because they put the lender at a lower risk. Secured credit is essentially backed by collateral.
Photo credit: iStock/kate_sept2004
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