Understanding the Risks and Benefits of Business Loan Collateral
July 26, 2021 | Last Updated on: July 24, 2022
July 26, 2021 | Last Updated on: July 24, 2022
There are many different sources for small-business financing. You can tap your own bank account or cash savings, turn to family and friends, win the favor of a wealthy investor looking to diversify his portfolio—or even seek a business loan. Looking into financing options can feel stressful and overwhelming for small business owners. This is especially true for first-time borrowers who may be unfamiliar with the terminology that lenders use. Financial institutions have a particular vernacular that can sound like a foreign language even to highly educated people, and it’s not always in their interest to help you understand what the fine print means or what the implications are for your business. To help you decide what the best type of loan is for your situation (and to avoid getting locked into a loan that you can’t afford), we’re going to take a deep dive into a topic that is frequently misunderstood: Loan collateral.
“Collateral” is one of those terms that can have multiple meanings depending on the context. For example, in the phrase “collateral damage” it means “secondary” or “indirect.” And according to Mirriam-Webster, it can also mean “reinforcing,” “belonging to the same ancestral stock but not in a direct line of descent,” and “informational materials.” But the relevant definition for our purposes here is, “property (such as securities) pledged by a borrower to protect the interests of the lender.”
To put that in English, when you see the word “collateral” in the context of a small business loan, it means that you’re pledging something of value (an asset) to the lender so that if you default on your loan, they can take possession of the asset in order to recoup their lost money. Often, the asset used as collateral is also the asset that the loan is being used for. For example, if you are seeking a loan to buy commercial real estate, the real estate itself will be the collateral, so that if you were to default on the loan and stop making payments, the lender would take possession of the property.
A loan that requires collateral is called a “secured business loan,” while those that do not require collateral are referred to as “unsecured business loans.”
As already noted, the form of collateral required can be commercial real estate, but it could also include business assets like accounts receivable, inventory, or equipment, and may also include the owners’ personal assets if the business is a startup or doesn’t have a strong credit history.
For obvious reasons, lenders prefer collateral-secured loans to unsecured loans. In fact, the collateral requirement is so common that the Small Business Administration (SBA) advises that, “before approaching a lender, you should assume that all assets financed with borrowed funds will be used as collateral for the loan” (emphasis added). While it is possible to get unsecured loans, generally, they are only available as small, short-term loans of less than a year.
Government-backed 7(a) SBA loans require blanket liens, which means that every asset your business owns is on the line to cover your loan. Loans larger than $350,000 require you to provide personal assets if your business assets will not cover the loan, and this personal guarantee extends to all owners with at least a 20% stake in the business. To prove eligibility for 7(a) loans you must show that your business assets meet minimum requirements.
In addition to the collateral requirement, government regulations mandate that you put up at least 5% of the loan amount as collateral. In other words, if your business is seeking a $100,000 SBA loan, you’ll need to come up with a minimum of $5,000 in collateral. If you’re seeking an equipment loan specifically, this collateral requirement can be reduced to 3%.
The specific collateral requirements for other types of government-backed loans, such as those offered by the USDA or Department of Energy (DOE), can be more complicated. So be sure to read up on the terms and conditions before applying for financing with those agencies.
If you are applying for a loan outside of the SBA, you can expect to pay higher rates and to have your collateral discounted by the lender. For example, you may have equipment worth $10,000 that you want to put up for the loan, but the lender will only accept it at a 20% discount, so the equipment is only worth $8,000 as collateral. Often, perishable assets like inventory are accepted at an even steeper discount due to the higher risk that lenders accept with it. For this reason, it’s often a good idea to get independent appraisal. This can help you advocate for a more reasonable collateral agreement that allows your business to keep its assets if it fails. Especially when the loan amount is substantial, and most definitely in cases where the collateral required consists entirely of equipment or real estate.
The formula for valuating assets for a loan is referred to as the Collateral Coverage Ratio (CCR). In the above example, the discounted value of the equipment is $8,000. To find the CCR, simply take the discounted value and divide it by the total loan amount. So if a business was seeking a $5,000 loan with this collateral, the CCR would be: $8,000/$5,000 = 1.6.
Typically when seeking a collateral backed loan, the lender will provide the CCR they require, and it is up to you to come up with the assets that will meet those requirements, which is why it is essential to have a clear understanding of the value of your assets when approaching loan negotiations.
In some cases it’s possible to take out a business loan without having to put any property at risk. The downside is that these loans tend to have higher interest rates than secured loans. You can think of it like the difference between a mortgage and a credit card. With a mortgage, your home secures the loan and as a result the interest rate is low, but if you you stop paying the loan, the bank can take your house. With a credit card, the interest rate is very high, but your line of credit is unsecured.
When your business’s loan application is approved and your lender offers you an interest rate, it’s likely that they will make you an offer with two different rates: one that does not require you to put up collateral and one that does. As noted above, secured loans typically have a much lower interest rate, as the lender has a right to your collateral should you default on the loan.
For this reason, secured loans are typically much easier to get than unsecured ones. Unsecured loans can be as difficult to obtain as personal loans for individuals with bad credit, and you may not even find a lender willing to offer you the terms you want. If you’re not eligible for a secured loan or don’t have enough collateral to meet the lender’s requirements, you can try for an unsecured loan if your credit is good enough, but keep in mind you are likely to face high interest rates.
Ideally, when a business owner takes out a loan, they do so only after writing a clear, data-backed business plan that makes a strong case as to why they need the financing to increase profits. That being said, even the best laid plans fail sometimes. If, as a result of some unforeseen circumstances, you default on your loan, the risk is that you may face penalties. The lender may sell off your property at auction as well as charge late fees and interest charges to recoup their money.
You may also be limited in your ability to sell or transfer ownership of the asset used as collateral. Typically, selling such an asset requires getting the lender’s consent and paying a release price. If the asset is sold without this, the lender may take legal action against both you and your buyer in order to recover the asset.
By contrast, if you are able to get financing through other means, either through investors, or by bootstrapping operations until cash flow improves, you can avoid these risks (although you may lose equity).
The benefit of collateral is that it provides stability to the loan package and gives your lender a means by which they can recover some or all of their money if things go wrong. As a result, you can expect lower interest rates and may have access to larger loan amounts and greater cash flow than you would with an unsecured bank loan.
Being smart about business financing means paying attention to more than just interest rates and repayment terms. You also have to know the risks you are undertaking if you put up collateral, and be willing to bet on yourself, your employees, and your business plan. Remember, in business everything is negotiable, so don’t be afraid to push back on the terms presented to you when you are collateralizing your loan. If you need assistance negotiating a business loan or exploring financing options, it is best to find a trusted financial advisor who can offer sound advice. You may also want to check with the SBA or your local SCORE chapter for assistance.
When determining the source of financing, it is important that you take into account how you plan to use the money that you borrow and evaluate all available options before deciding which one is right for your business. It is also a good idea to determine whether there are any discounts or incentives associated with certain options and make sure that you are aware of them before formally requesting a loan.
You should also be aware of the different types of lenders, such as banks, micro-lenders, non-profits, government agencies and more when trying to determine which one is right for your business and what kind of loan products make sense for you.