What Is Collateral & Do I Need It For A Business Loan?
To push your business forward, you’ve decided to apply for a business loan. You’ve decided how much money you need and how you will spend it. Maybe you’ve even done some research on lenders in your area. Now, it’s time to navigate the application process.
For even the savviest business owners, getting a business loan can be a challenge. Selecting the right loan and researching APR and repayment terms can be tricky. Gathering the right documentation and understanding the requirements of taking the loan can be time-consuming. In addition to business and personal documentation, your loan will have other requirements, including collateral.
If you’ve ever taken a loan before, you’re likely familiar with collateral. However, if you’re new to borrowing, this seems like just another piece of the financing puzzle to figure out. Luckily, the concept of collateralizing loans isn’t difficult at all.
Read on to learn more about collateral, what qualifies as collateral, and why it’s required for business loans.
Table of Contents
What Is Collateral?
Collateral is an asset used to secure a loan and reduce the risk of lending to a small business. In the event the borrower cannot make loan payments, the collateral can be seized and resold to cover the remainder of the loan.
In other words, collateral is something of value that shows the lender you are prepared to pay your loan.
Lenders loan money to businesses and consumers, but this can be a big risk. Even though most people and businesses have good intentions, sometimes they fall upon hard times and become unable to make their loan payments. Other times, there may be unscrupulous borrowers who don’t plan to pay back the loan at all. With collateral, a lender can protect itself.
A lender puts a lien on the asset or assets that are pledged as collateral for the loan. If the borrower goes into default, the lender has the right to seize the property, which can then be sold to pay off the debt. This process ensures that if a borrower stops paying on a loan, the lender will get still get paid.
Collateral doesn’t just benefit the lender. By pledging collateral, a business owner can show the lender that they aren’t a high-risk borrower. Offering collateral could lead to reduced interest rates, which ultimately results in a more affordable loan. Collateral can also help open up other financing options for borrowers, such as higher loan amounts or loans they would otherwise not be qualified to receive.
Can I Get A Business Loan Without Collateral?
Whether collateral is needed for a loan depends on the amount of the loan, the loan taken, the creditworthiness of the borrower, and the policies set by the lender. For installment loans of a smaller amount, specific collateral is not required.
Collateral is generally not required for business loans like lines of credit, credit cards, and short-term loans. However, it is important to note that while the lender may not require specific collateral, a personal guarantee is usually required for most business loans.
Signing a personal guarantee means that all owners (generally anyone with a 20% or more stake in the business) acknowledge they will be held personally responsible for repayment. In other words, personal assets can be seized to pay the debt owed if you default on a loan and have signed a personal guarantee. Additionally, the lender can take legal action if needed. In this scenario, collections, missed payments, late payments, or defaults will appear on the personal credit reports of the owners.
For some business loans, a UCC-1 blanket lien might also be required. A blanket lien gives a lender the legal right to seize any and all of the borrower’s assets if the loan isn’t paid.
Collateral requirements, blanket liens, and personal guarantees will be established in your loan contract. Before signing, make sure you understand the collateral policies put in place by the lender.
What Can Be Used As Collateral To Secure A Loan?
Each lender will have their own policies about what type of collateral can be used to secure a loan. In general, however, anything of value can be used to back a loan.
For a business loan, business assets such as equipment, vehicles, buildings, and inventory can be used as collateral. Accounts receivables can also be used as collateral. Any business asset that has value and can be sold by the lender to pay off the loan if necessary can be considered collateral.
Common types of collateral for small business loans include:
- Real estate
- Accounts receivable
- Future sales
- Cash reserves
As mentioned above, for many business loans, the lender might require a personal guarantee in addition to collateral. If you sign a personal guarantee, personal assets such as vehicles, real estate, or personal cash could be seized to pay back the loan in the event of a default.
While some loans may require business owners to pledge a specific asset, other lenders will require a blanket lien. A lien gives the lender the right to all of a borrower’s business assets, which can be seized to pay off the loan if the borrower defaults.
How Much Collateral Do I Need For A Loan?
The amount of collateral you will need for a loan will vary depending on factors such as the amount you want to borrow, the type of loan you are applying for, and your credit score. You may have to pledge collateral equal in value to up to 100% of the amount borrowed.
The loan amount is one factor that will need to be considered. A loan of a higher value will almost always require collateral. Many lenders require loans exceeding a certain amount to be backed with commercial or personal real estate. Smaller loan amounts may not require specific collateral but will come with a personal guarantee or blanket lien requirement.
Business owners with low credit scores or no credit history may also be able to qualify for a loan by securing it with collateral.
Different types of loans also require different types of collateral. For example, the collateral for equipment financing is the equipment itself. On the other hand, you may be required to put up specific business assets or sign a personal guarantee to qualify for an installment loan.
Again, it’s important to fully understand what collateral is required based on the loan you’re pursuing. Be sure to thoroughly read your contract and discuss any concerns you have with your lender.
Types Of Business Loans That Commonly Require Collateral
Most business loans do require some form of collateral, whether it is property or takes the form of a personal guarantee. Before jumping into the loan application process, know what type of collateral is required based on the type of business loan you’re applying for.
Commonly required collateral by loan type:
- Bank loans: Business assets, personal guarantee, blanket lien
- SBA loans: Business assets, personal assets, personal guarantee
- Commercial real estate loans: The real estate being financed
- Equipment loans: The equipment being financed
- Inventory loans: The inventory being financed
- Invoice financing: Accounts receivable
Learn more about each type of loan and its collateral requirements below.
Bank loans are very common for business owners since these loans can be used for almost any business purpose and come with extremely competitive rates and terms.
The collateral requirements for bank loans vary. However, at the very least, a personal guarantee or blanket lien is required. With some bank loans, though, specific collateral is required by the lender, especially for higher loan amounts. If specific collateral is required, this could be in the form of business assets including buildings and equipment, or in some cases, personal real estate or assets.
Small Business Administration (SBA) Loans
Small Business Administration loans are loans that are guaranteed by the SBA. These loans are distributed through intermediary lenders, which includes banks, credit unions, non-profit organizations, and Certified Development Companies.
All SBA loans require some form of collateral, even if it’s just a personal guarantee. For example, specific collateral is not needed for SBA 7(a) loans up to $25,000. Standard 7(a) loans that are more than $350,000, on the other hand, will need to be fully collateralized by the borrower. Business assets and in some cases, personal real estate, can be used as collateral. For the SBA 504 loan program, the collateral is the asset being financed with the loan proceeds.
Even when specific collateral is not required, having collateral can potentially help business owners better qualify for some SBA loan programs.
Commercial Real Estate Loans
Commercial real estate loans are loans that are used to purchase land or commercial real estate. These loans can also be used to refinance existing commercial real estate loans or to fund additions to existing facilities.
Commercial real estate loans are similar to personal mortgages when it comes to collateral. Instead of pledging something that is already owned, the real estate being purchased with the loan proceeds serves as the collateral. This means that if the business owner defaults on the loan, the land or building can be seized by the lender and sold to pay off the debt.
An equipment loan is used to purchase new equipment needed by a business for operations. Typically, the collateral for this type of loan is the equipment being purchased with the borrowed funds. If the borrower defaults, the equipment can be taken and sold to pay off the remaining balance of the loan.
Inventory loans are a type of financing used to purchase inventory for a business to sell to its customers. If the business cannot sell the inventory and is unable to make the loan payment, the inventory purchased with the loan proceeds serves as the collateral.
Invoice financing is a type of loan that is given for unpaid invoices. Invoice factoring allows a lender to pay the business a percentage of the invoice. The lender collects payments for the invoices and once paid, pays the remainder of the invoice total to the business, minus interest and fees charged for the service.
Invoice discounting is another type of invoice financing. The business is paid a lump sum for the unpaid invoice, which is generally 90% to 95% of the total amount. Once the business collects the payment from the customer, the loan is paid back to the lender, along with the remaining percentage for interest and fees.
With both types of invoice financing, the unpaid invoices serve as the collateral.
Business Loans & Collateral: Final Thoughts
Before applying for a loan, make sure that you fully understand the need for collateral. Not only does this provide the lender with the protection it needs to confidently loan money to businesses, but it also can help pave the way for you to get a loan.
Before signing your loan paperwork, make sure that you fully understand what you are putting up as security and analyze your personal financial situation to ensure you’re not stuck with a bad deal further down the road. Shop around for better loan options if you need to. With proper planning, a little knowledge, and responsible borrowing, pledging collateral to obtain a business loan will only help you get the money you need when you need it.