Trying to secure a small business loan? If so, taking inventory of your assets is a vital part of the process. Personal savings, debts, income, and expenses will all be considered, but what about your property?
Since the housing crisis, times have changed. Real estate was once looked on more favorably by lenders than other collateral, but real estate is no longer the deal-clincher it once was. On the contrary, owning property is now a significant roadblock for small businesses trying to secure funding because it often causes more financial hardship by putting their assets at risk.
Understanding asset-based loans
Before accepting why real estate might not be your best asset (and considering other lending streams), you first need to understand how a lender views your assets.
Asset-based lenders look to secure their loans using tangible or non-tangible assets owned by the applicant. These might include your house, business premise, land or shares. These assets aren’t just proof of your financial health; you’re essentially putting your investments, savings and even your home on the line to gain money for your business now. This is often referred to as a “secured” loan.
What about mortgages?
Lenders who are willing to make asset-based loans using real estate know that the borrower most likely already has a mortgage on their property. Many lenders are willing to take second positions subordinate to the mortgage lender and still provide financing.
What is Collateral?
If you opt for an asset-based loan, the property owned by you (or owned by the business) will be used as collateral. Your real estate essentially provides the lenders with the additional security they need, but it puts your property in jeopardy.
Often, this route is used by businesses with poor credit or no other capital, and funding is usually provided for up to 90% of the property’s value. Funding can be provided for up to 90% of the value of the property. Unlike more traditional real estate loans, the money can be used for a variety of business needs or to smooth over any cash flow issues.
Why do businesses borrow real estate equity?
Small businesses often use personal or commercial real estate as the basis to obtain a loan, either because they have less than perfect credit, or because they have equity in their land or building. In any case, these business owners end up taking a risk – putting forward their homes or business premises as a guarantee that they will pay the money back in full and on time.
Why real estate might not be your best asset
There are many reasons why real estate may not be your best asset and many different alternatives. Before we look at other options, these are the reasons you may reconsider securing a loan against your property:
Real estate is an illiquid asset
During a typical loan application, a lender will look for evidence of liquid assets. Liquid assets are assets that are either cash or can quickly be converted into funds to cover you if you lose your primary income source. You’re more likely to be accepted for a loan and get a better rate if you have liquid assets to fall back on, as there is less chance you’ll default on your payments.
Illiquid or fixed assets, on the other hand, take longer to convert into cash, and their value may change in the process. Real estate is illiquid because the value of a property is always changing, plus the sale process takes a long time and is dependent on other factors.
Real estate can become collateral
By offering real estate as security, you ’re giving the lender a legal claim to your property should you default on your payments. It means that if you don’t stick to the repayment plan, your property could be repossessed or sold in lieu of payment.
Asset-based loans cost more than traditional loans
Despite the advantages of asset-based loans, they can also be expensive. Interest rates vary, and banks will sometimes add on audit and due diligence fees to the overall cost of an asset-based loan. Larger banks might also require a personal guarantee as well as confirmation of any other banking relationships.
A third party could manage your cash flow
In most cases, asset-based lenders will require that your customers send payments directly to the finance company, which mean a third party gains control of your company’s cash flow. The lender, for example, might “reserve” more cash from customers instead of turning it over if receivables lengthen.
Alternatives to home equity financing
There are many alternatives to home equity financing, including:
- Unsecured small business loans: You can find government-backed unsecured small business loans for up to $500,000 by searching online.
- SBA loans: the US Small Business Administration is designed to provide financing for the purchase of fixed assets, which usually means real estate, buildings, and machinery, but at below-market rates. These are referred to as SBA loans.
- Business loans for women: There is an increasing number of small business loans for female entrepreneurs. In addition, there are women-only business grants, mentorship programs, and other resources that can provide revenue for your business.
- Business line of credit: A line of credit will give you access to a specific amount of money, but you don’t need to use all of it. In this instance, you only pay interest on the funds you draw out. Once you’ve paid back what you borrowed, your credit line goes back up to its original amount.
Secured loans are less risky for lenders, but they are incredibly risky to the borrower. Defaulting on an asset-based real estate loan means your lender could reclaim the outstanding debt from your property or force you to sell.
To borrow home equity effectively, you need stable interest rates and rising home values. In other words, this strategy works best in a strong economy, but you also need to shop around if you want to find the best rates. Even if you’re operating in a healthy economic environment, many financial planners will warn you not to borrow from home equity for any or all of the reasons mentioned above.
Thankfully, there are other lending streams– such as small business loans and unsecured loans – that could provide the cash injection your business needs without putting your property on the line.