How much collateral you need for a business loan can vary. Some lenders won’t require any specific collateral, instead opting for a personal guarantee or general lien. For others, collateral is a must.
If your business meets the criteria for a bank loan, chances are you’ll have to secure that financing with some form of collateral, typically equal to or greater than the value of the loan.
We’ll walk you through the ins and outs of putting up business collateral so you can get the working capital your company needs to grow.
What Is Business Collateral?
Collateral is an asset that a borrower provides a lender to secure a loan. Assets can be tangible, which can be seen and touched, such as buildings, or intangible, such as accounts receivables.
Lenders assume financial risk whenever they hand money over to a business looking to scale. To mitigate that risk, many creditors require business collateral.
Even though lenders take precautions to vet applicants to allow only the most creditworthy borrowers, most banks still insist that business owners offer collateral to hedge the inherent risk of lending. Indeed, an impressive credit history, positive cash flows and other attractive attributes aren’t enough to bypass this requirement.
Chances are you’ll need to set aside a sum of cash or other assets to get approved for a business loan. According to the Small Business Administration (SBA), business owners looking to borrow funds that require collateral should assume that all assets financed with their loan will be used to secure that loan, though additional assets may be needed.
Small Business Loan Collateral for SBA Loans
Do SBA loans require collateral? The answer, usually, is yes.
Loans secured by the SBA often require collateral to minimize the associated risk. However, a borrower applying for an SBA loan won’t be declined due to inadequate collateral alone.
How Much Collateral Is Needed for an SBA Loan?
For standard SBA 7(a) loans greater than $350,000, lenders must obtain as much collateral as possible, up to the loan amount.
For SBA 7(a) small loans from $25,000 to $350,000, lenders follow the collateral policies they’ve established for non-SBA commercial loans. At the least, the lender must take a lien on all a borrower’s fixed assets, including real estate, as well as take a first lien on assets financed with loan proceeds.
SBA 7(a) loans of up to $25,000 don’t require collateral.
How Is the Value of Business Collateral Determined?
For loans that require business collateral, an appraiser will value the assets you’re pledging to secure the loan. It could be one item or several. The appraiser is licensed and is hired by your lender to conduct a certified appraisal.
The lender then “discounts” the appraised value of the asset based on their policies. One example is real estate serving as collateral, which according to the SBA, can be discounted at 80%.
You might be wondering why lenders discount the value of your assets. The value assigned to an asset often is lower than the fair market value of the item because the lender may need to sell property quickly to recoup funds in the event of default.
Also keep in mind the value of assets can change over time, in which case the value may need to be reassessed down the line, particularly if there are extended loan terms.
Loan-to-Value Ratio and Business Collateral
Loan-to-value (LTV) ratio refers to the total loan amount and how it compares with the value of the collateral you’ve offered to secure the loan. The LTV ratio provides lenders with a convenient, bite-size assessment of the risk of approving a loan.
The higher the LTV ratio, the riskier the loan is for the lender. Typically, an LTV ratio of 80% or lower is best, although collateral for business loan approvals may be necessary. Keep in mind, the lower the LTV ratio, the lower your interest rate will likely be.
Examples of Collateral for Business Loans
There are several types of business collateral for loans that range across several asset classes.
Whenever we’re asked, “What can be used as collateral for a business loan?” we’re tempted to say “whatever can be liquidated fast,” because banks and lenders need collateral that can be quickly converted into cash. That’s why cash itself is often preferred over most other forms of collateral.
Although some business loans have been secured with rather eccentric assets, including wheels of cheese, most banks rely on one of the following types of collateral for small business loans.
When it comes to taking out a business loan with collateral requirements, cash is king. Although it may seem like a paradox to secure a cash loan with cash, a cash-secured loan is common. This is because cash-secured loans give lenders the ability to instantly recoup their losses in case you default.
Typically, a cash savings account held by the owner of the business (at the same bank) will be used to secure the loan. As a result, the creditor can quickly liquidate the cash in the applicant’s savings account immediately after they default on the loan.
Consequently, cash-secured loans present a very low-risk solution for lenders.
On the other hand, allowing a lender to reclaim your life savings presents a high-risk opportunity. If you’re forced to default because of outside circumstances, then your personal financial security can be jeopardized.
Although property and physical real estate can be more difficult to convert to cash, they are another form of business collateral widely accepted by creditors and lenders. Buildings, equipment, inventory, vehicles and homes can all be used as forms of collateral after being appraised by an independent party.
Be sure to consider the risk involved whenever you back your business loans with property. While real estate is one of the most common forms of collateral for business loans, if you default on your loan, you may lose your home. The same holds true for any other property pledged as collateral.
One of the unsung forms of collateral business owners can use is their company’s inventory. Keep in mind that conditions apply when it comes to using inventory as small business loan collateral. For instance, the value of inventory may depreciate—some very quickly. These assets may have to be appraised by an independent third party.
Inventory financing is one of the most effective ways to use your business’s inventory as collateral. This financing option involves the business owner taking out a loan for purchasing inventory items that will later be available for sale. However, since the value of the inventory is uncertain and subject to volatility, some lenders may be averse to offering inventory-secured loans.
invoices, or accounts receivables, are fast becoming one of the most popular examples of collateral, offering small business owners who don’t have enough cash on hand a way to secure their loan.
Invoice financing involves lenders accepting outstanding invoices as a form of collateral. For business owners who don’t have the credit score needed to get approved for a loan, invoice financing provides a reliable option for locking down borrowed capital.
For those who need working capital as fast as possible to keep their businesses running efficiently, invoice financing provides a reliable option.
Securities are another form of collateral considered by banks and other lenders. The following types of securities can be acceptable forms of business collateral because they can be bought and sold on capital markets:
- Treasury bonds
- Certificates of deposit (CDs)
- Corporate bonds
When most people ask themselves, what is collateral in business, they don’t think of a lien. A blanket lien is a legal right granted by the owner of a property to a second party to seize it in the event of default.
Technically, a blanket lien is a contract that affords the lender the right to reclaim the borrowed assets if the terms of the contract aren’t met. For this reason, blanket liens protect lenders. However, they offer no protection to borrowers.
Borrowers considering taking out a loan backed by a blanket lien should be aware that most banks will refuse this option unless they’re in a first-lien position. In other words, creditors want to be the first lender to file a blanket lien on your assets. Otherwise, they will have the second or third claim on your assets if you default, which means they may end up empty-handed.
Common Types of Collateral by Loan Type
For secured loans, the following collateral types are often pledged by borrowers:
- Short-term loans: Cash, inventory, receivables
- Medium-term loans: Vehicles, real estate
- Long-term loans: Real estate
Finding Your Best Option for Collateral
No borrower should assume that a secured business loan is automatically the best financing option for them. While it can be convenient, it can present a great deal of risk if you default on the loan. However, those with poor business credit might have no choice but to agree to secure their loan.
Knowing the amount of collateral required for a business loan is mostly a matter of negotiating with your creditor. Usually, business collateral should be roughly equal to the value of the loan in question. From the examples of collateral listed above, consider using whatever you have on hand and can risk losing if the matter of default ever arises.
For instance, if you secure your business loan with your personal real estate, not only does this put your business at risk, but your personal finances as well. Therefore, always exercise discretion before using business collateral to secure your loan.
To Secure or Not to Secure: That is the Question
There’s no way around it: You need cash to grow your business. No matter your industry or what type of company you operate, reliable access to funding is crucial.
Research your secured and unsecured loan options and determine if a business loan with collateral requirements is best for your business.