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When researching how to get a business loan, you’re sure to come across a common term: collateral. Collateral is a common business loan requirement, but it is not necessary with all types of business financing.
Some lenders want you to post collateral when you take out a new business loan. Others will not require collateral when your business borrows money. Finally, some lenders may allow you to decide whether or not to provide collateral when you borrow, and the cost of your loan may vary depending on your decision.
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What is the warranty?
Collateral is a term that describes an asset that you pledge to a lender when you take out a loan. If your business borrows money and fails to repay the debt as promised, collateral provides another way for the lender to recover their investment by seizing the asset. The guarantee, at its core, is a security measure.
When you give a guarantee to a lender, your loan is guaranteed. The financing that you subscribe without any guarantee is not guaranteed. So, if you’re researching financing options for your business and come across the term “secured,” you know that some sort of deposit or security is required by the lender. Unsecured financing indicates otherwise.
Common Types of Collateral for Business Loans
Lenders may accept a variety of different assets as collateral, depending on your type of business loan and other factors. The following are examples of acceptable collateral for business loans:
- Real estate
- Professional equipment
- Accounts Receivable
- Investments (i.e. stocks, bonds, etc.)
- Personal property
In some cases, the property you are borrowing money for, such as an office building, commercial vehicle or equipment, can serve as collateral for the loan. Say, for example, you borrow money to buy a truck for your business. However, your company is falling behind in its payments. In this scenario, the lender can repossess the vehicle (seize the collateral) and resell it to a third party.
How much collateral do commercial lenders need?
The amount of collateral you must provide to a lender for a secured business loan depends on many factors. Your credit (business and personal), repayment capacity, capital availability and loan terms, all of which are part of the five Cs of credit, can influence a lender’s collateral requirements.
If you need to post collateral to secure the financing, there is a general rule that most lenders follow. Any assets you pledge must be worth at least as much as the amount your business wants to borrow.
In other words, if you want to take out a $100,000 secured business loan, you may need to provide $100,000 collateral to secure the financing. Pledging assets to the lender that match or exceed the amount of financing your business needs reduces lender risk and can make you a more attractive borrower.
The value of the guarantee
There is another key factor at play that you need to understand when it comes to warranty. Your definition of value may not match a lender’s definition. The value of the guarantee is subjective.
Imagine you have a property valued at $100,000 and you want to pledge it as collateral for a business loan. The lender probably won’t give you credit for the full appraised value of the asset. Instead, the lender may consider the property to be worth only 80% to 90% of its appraised value, just in case the lender cannot resell the property at full value for whatever reason.
This reduction in value can impact the amount of money your business can borrow. If a lender only accepts 80% of the value of your property in the scenario above, you will only have $80,000 collateral. In this case, you will probably need to do one of the following:
- Provide additional collateral that the lender will accept
- Provide a larger down payment
- Borrow less money
Collateral by type of commercial loan
The type of business financing you want will also play a role in the collateral requirements you need to meet. It is important to check with any lender you are considering doing business with to find out their specific loan requirements.
Below are some examples of collateral you might expect to provide for different types of business financing.
- Equipment financing: When you finance equipment for your business (manufacturing, construction, or otherwise), the asset you are financing typically serves as collateral for the loan.
- Online business loan: If you borrow money from an online lender, you may not need to provide traditional collateral. Instead, an online lender may require a personal guarantee or perhaps a general lien to protect their investment. A general lien gives the lender the right to take back any collateral your business has if necessary.
- Invoice Factoring: With invoice factoring, your unpaid invoices act as collateral for your business loan. In practice, your company sells its unpaid invoices to a factoring company and receives an advance, usually 80% to 95% of the invoice value. The factoring company then collects the unpaid invoices and you pay a factoring fee (usually around 0.50% to 5% per month) until your customers settle their outstanding balances.
Can you get a business loan without collateral?
It is possible to qualify for a business loan without providing collateral to back your financing. But, if you are looking for an unsecured business loan that does not require collateral, the lender is taking on a greater risk. As a result, there may be trade-offs, including:
- Your choice of lenders may be more limited. If you want to take out an unsecured business loan, some lenders might not want to work with you. Some U.S. Small Business Administration (SBA) loans, for example, may have non-negotiable collateral requirements. Online lenders, in comparison, may be a better resource for unsecured business loans. But you may still need to sign a personal guarantee to cover the lender in the event of default.
- You may need better credit to qualify. Business lenders often consider both your business and personal credit score when applying for a business loan. If you want an unsecured business loan, especially from a traditional lender, the minimum credit criteria may be stricter than it would be if you pledge assets.
- Interest rates and other loan terms may be less attractive. Unsecured loans are riskier for the lender. As a result, the lender may charge you more, lend you less money, or request a larger down payment to help offset the additional risk exposure.
Note that even if you qualify for unsecured business financing, you may need to agree to provide a personal guarantee. With a personal guarantee, a lender or credit card issuer may have the right to take legal action and pursue your personal assets if your business defaults on its debt.
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Frequently Asked Questions (FAQ)
Is a personal guarantee the same as a guarantee?
Personal guarantees and guarantees are intended to help protect the lender’s investment in the event of default. But they offer this protection in different ways.
With a personal guarantee, the lender has the right to hold you personally liable for the debt incurred by your business. Collateral, in comparison, gives the lender the right to take possession of the specific assets you have pledged to secure the loan.
If you put equipment or inventory as collateral, for example, the lender could seize those assets and try to resell them. This repossession process can help the lender recover some or all of the outstanding balance remaining on your debt.
How much collateral do you need for an SBA loan?
The SBA offers several different loan programs to eligible small business borrowers. Collateral requirements on an SBA loan vary from one type of loan to another.
For SBA loans below $25,000, the SBA does not require lenders to post collateral. But personal guarantees are still essential for anyone who owns at least 20% of a business.
On the other end of the spectrum, SBA loans over $350,000 require full collateral, equal to the full loan amount your business is borrowing. And with other SBA loans, like the SBA 504 loan program, the asset your business is financing serves as collateral for the loan.
Does the guarantee improve my chances of approval?
The ability to provide collateral can improve the chances of your business loan being approved by some lenders. Having assets to pledge to a lender can also open more doors for your business, giving you more opportunities to borrow money from more lenders.
With business loans with bad credit, the provision of collateral can be particularly helpful. Remember that lenders only approve loan applications when they feel the overall level of risk is acceptable. Bad credit increases a lender’s risk of default, but acceptable collateral can help shift a loan’s risk level in a positive direction.