Collateral is required by many lenders, but it can also benefit you when applying for funding. Here's what you need to know about pledging collateral for your small business loan.
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As part of the application process, you may be required to provide collateral for a business loan. But what is collateral, and why does your lender require it?
In this post, we’ll break down what qualifies as collateral, why some loans require it, and how collateralizing your business loan benefits you.
What Is Collateral For A Business Loan?
Collateral is an asset used to secure a loan and ensure that the lender gets paid. The asset used as collateral is something of value that shows a lender that you’re prepared to pay off your loan. In the event that you are unable to make your loan payments, the lender can seize your collateral and sell it to cover the remainder of your loan.
Securing a loan with collateral decreases the risk a lender takes on. As a result, the lender is more likely to loan money to a small business.
Why Do Lenders Require Collateral?
Collateral allows a lender to protect itself by alleviating some of the risks that come with lending to individuals and businesses.
The lender places a lien on the asset (or assets) that is pledged as collateral for the loan. If you default, the lender has the right to seize the property and sell it to pay your remaining debt. Collateral ensures that if a borrower stops paying, the lender will still get paid.
However, collateral is not just in place to protect the lender. When a business owner pledges collateral, they can prove to the lender that they aren’t a high-risk borrower.
Collateral can lead to reduced interest rates and higher borrowing limits. Collateral can also help you get approved for loans you wouldn’t be qualified to receive otherwise. Reduced interest rates lead to a more affordable loan, and alternative financing options can also be less expensive in the long run.
Can I Get A Business Loan Without Collateral?
There are certain loans that may not require specific assets to be used as collateral. However, these loans may require a blanket lien or personal guarantee.
Financing Options That Don't Require Collateral
Financing options that generally do not require collateral are:
Keep in mind that even if a lender doesn’t require specific collateral, many business loans still require a personal guarantee.
Several factors may also determine whether collateral is required. This includes the size of the loan, the borrower’s credit score, and the lender’s policies.
A personal guarantee requires that all owners of a business acknowledge that they will be held personally responsible for the repayment of a loan.
If you sign a personal guarantee, your personal assets can be seized to pay the remainder of the debt owed if you default on a loan. Additionally, a lender can take legal action against borrowers if needed. Keep in mind that a personal guarantee also means that collections, missed payments, late payments, or defaults will appear on the personal credit report of the signers.
UCC-1 Blanket Liens
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. In addition to tangible business assets like existing inventory and equipment, a lender can also seize your accounts receivables and even your future inventory.
Blanket liens don’t allow a lender to seize your personal assets. The only time you’d have to worry about your personal assets being touched is if you signed a personal guarantee. Be forewarned that most lenders that require a blanket lien also require a personal guarantee.
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 your lender.
What Can Be Used As Collateral For A Business Loan?
Each lender will have their own policies about what type of collateral can be used to secure a loan. In general, 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 receivables
- Future sales
- Cash reserves
The lender might also 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.
How Much Collateral Do I Need For A Loan?
The collateral required for a small business loan is based on a number of factors, including:
- Loan Amount: Higher loans almost always require higher-value collateral like commercial or personal real estate.
- Type Of Loan: The collateral required varies by loan type. An example of this is that the collateral for equipment financing is the equipment itself.
- Credit Score: Business owners with low credit scores or no credit history may be required to provide collateral in order to secure a loan.
Be sure to thoroughly read your loan contract to learn the specifics of the collateral required and discuss any concerns you have with your lender.
Types Of Business Loans That Commonly Require Collateral
Whether the collateral is property or a personal guarantee, most business loans require some form of collateral. Here’s what to expect based on each type of loan.
Commonly required collateral for bank loans includes:
- Business assets
- Personal guarantee
- Blanket lien
Bank loans are popular with business owners because they can be used for almost any business purpose and have competitive rates and terms.
Collateral requirements for bank loans vary. At the very least, a personal guarantee or blanket lien is going to be required. Some lenders may require specific collateral for higher loan amounts — typically in the form of business buildings and equipment or personal real estate and assets.
Commonly required collateral for SBA loans includes:
- Business assets
- Personal assets
- Personal guarantee
Small Business Administration loans are loans that are guaranteed by the SBA. These loans are distributed through intermediary lenders, which include 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. Business assets are used as collateral, although personal real estate may be accepted in some cases. 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
Commonly required collateral for commercial real estate loans includes:
- The real estate being financed
Commercial real estate loans 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.
Commonly required collateral for equipment loans includes:
- The equipment being financed
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.
Commonly required collateral for inventory loans includes:
- The inventory being financed
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 collateral.
Commonly required collateral for invoice financing includes:
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 collateral.
The Bottom Line On Collateral For Small Business Loans
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.
Collateral For Business Loans FAQs
What qualifies as collateral?
Common types of assets used as collateral include real estate, buildings, equipment, vehicles, inventory, accounts receivables, future sales, and cash reserves.
Is collateral required for a working capital loan?
Collateral is not required by every lender to get a working capital loan. However, you might have to agree to a blanket lien or sign a personal guarantee even if specific assets aren’t required.
Can I get a collateral loan with bad credit?
You can generally get a loan with collateral if you have bad credit. Lenders are more willing to lend to you if they have collateral to collect in the event that you default on your loan.
Is a personal guarantee the same as collateral?
A personal guarantee may be used in conjunction with or in lieu of specific collateral. By signing a personal guarantee, you are telling the lender that you can be held personally liable for the loan if it goes into default. With a personal guarantee, lenders can seize personal assets as needed to recover funds lost to a defaulted loan.