Let’s say you approach a lender looking to get a business loan.
Your lender asks you to turn in a pile of documents. If this wasn’t enough, they inform you that you also need to pledge collateral. In other words, you need to put up some sort of property that your lender can seize if you fail to pay back the loan.
This sounds terrible, right? No one likes putting at stake their own assets or property!
But… is there an alternative?
Or is actually it a good option? Could it have some benefits you don’t know?
What are the pros and cons of using collateral to secure a business loan?
Keep on reading to find out everything you need to know about this requirement when applying for a business loan.
What is Collateral?
Collateral is some sort of asset or property that you offer to a lender to obtain a loan. In case you fail to make the promised payments, the lender can take advantage of the collateral to recoup the losses.
Let’s assume you need to borrow $100,000 to start your business. Since your business is quite new, the bank may hesitate to lend you the money. So they may require you to pledge your home as collateral (provided that the value of your house is similar or above $100,000) as a guaranty that can be seized if you don’t return your loan.
Technically speaking, pledging collateral includes a blanket lien. A lender can seize your assets if they get a first lien on those assets. This means, if everything goes wrong and you fail to pay back the loan, the lender can seize the assets without the interference of other creditors who are trying to do the same.
For instance, a bank has a first lien on your home when you get a mortgage, meaning they have rights to your title until you pay the loan in full. After you pay off, their name gets taken off the title.
To sum up, collateral provides lenders with security should you fail to pay back your debt.
Apart from offering assurance to lenders, it ensures lower interest rates to borrowers, so if high interests are your main concern, the option of putting up collateral can be also beneficial for you.
Types of Collateral
There are seven common types of valuable assets you may pledge to get a small business loan.
1. Real property
Real property (or property collateral) refers to real estate and home equity, but also cars, motorcycles or boats. It is the most common collateral because of its high value and immediate availability.
Many small business owners have access to home equity, so this is an obvious choice to secure a business loan. However, keep in mind that you’ll put your family’s home at risk if you fail to repay the debt.
This type of collateral is viable if you have a product-based business. The lender sends a third-party auditor to estimate your inventory and calculate its value.
If the lender doesn’t consider it as valuable or resalable, you might not be able to obtain the loan with the help of this collateral.
In case you want to get funds to buy specific equipment, the equipment itself can serve as collateral. If the lender estimates that the gear you want to purchase has a chance to retain its value during liquidation, you’ll probably get better terms.
Another form of collateral is cash, as a business saving account.
For lenders, there is no hustle and bustle of selling assets; they can easily reimburse the debt in case you default on your loan. But, for you, it’s a huge risk because you might lose all your savings.
5. Unpaid invoices
If your clients are slow with their payments, you can pledge those unpaid invoices as collateral. It’s an excellent option for small business owners who don’t have a good credit score since lenders determine your viability through the value of those invoices.
6. Blanket Liens
A lender’s claim to a borrower’s collateral is called a lien. A blanket lien on business assets is a lien that gives the lender the right to seize, in the event of nonpayment, all types of business assets that you have put up as collateral.
Although technically it is considered collateral, have in mind that a blanket lien doesn’t prevent the borrower from pledging their assets as collateral for another loan.
“Blanket” really means “any” unpledged collateral. Therefore, you can get an unsecured loan with a blanket lien on your assets (including any equipment), and then get a secured loan which pledges a particular piece of equipment.
Considering all this, a blanket lien is actually a very weak form of collateral and will not reduce the rate of your loan because, again, you have the flexibility and freedom to pledge any collateral.
7. Personal Guarantees
Similar to a blanket lien on business assets, a personal guarantee is a blanket lien this time on your personal assets. It allows the lender to seize any personal assets that you pledge as collateral.
Like a blanket lien on business assets, it won’t help you that much to get your interests reduced
Unsecured vs. Secured Loans
Understanding the difference between secured and unsecured loans helps you estimate your chances of getting the loan and your interest rates.
Secured Business Loans
With a secured loan your lender has the right to request a first lien on pledging your assets.
This right offers certain security to the lender, and that’s why it’s called a secured loan.
A secured loan is less risky for the lender because they can easily seize the pledged assets with a first lien without worrying that another creditor may seize the assets before them. The amount of collateral required depends on the lender’s terms, the type of the loan, and the amount you intend to borrow.
The value of assets proposed as collateral is determined through a process called certified appraisal. It consists of an evaluation of any property, such as real estate, carried out by a certified person.
The positive side is that due to this assurance, it’s more likely to get a loan and get lower interest rates. However, with this secured loan you’re at risk of losing some valuable personal assets, savings or even your whole business if you fail to pay back the loan.
Unsecured Business Loan
On the other hand, an unsecured loan doesn’t need collateral.
If you fail to repay your debt, the decision on what happens with your collateral has to be resolved in court, so this collateral is not considered a safety net for the lenders, and it won’t be factored into the loan terms. In other words, there are a lot of chances you’ll still get higher interest rates, and your loan ends up being more expensive.
What Types of Business Financing Require Collateral?
After learning all you need to know about collateral, there is one last question that needs to be answered—what types of business financing require collateral?
- Asset-Based Financing is the type of financing extended to fund a particular asset or purchase, such as inventory or equipment, which serves as collateral at the same time.
- Equipment Financing is a form of asset-based lending where you get a lump sum to purchase desired equipment, which acts as collateral.
- Secured Business Lines of Credit allow you to obtain a credit line instead of a lump sum, but also to borrow higher amounts of money with lower rates.
- Accounts Receivable Financing, also known as invoice financing. For this option, lenders take a small percentage of every unpaid invoice to get paid back.
- Term Loans are a lump sum of capital that you return with regular payments at a fixed interest rate. The lender may ask some kind of collateral to minimize the risk.
Types of Unsecured Business Financing
Business Credit Cards
This is one of the most used financing options among small business owners. It’s a quick way to raise money for the various needs of your company and to meet your working capital requirements.
One of the greatest advantages of a credit card is that applying for one doesn’t require any collateral. Also, it provides a revolving line of credit, meaning you borrow precisely the sum that you need and no more.
But these two features come at a high cost: the interest or Annual Percentage Rate (APR) on the money that you borrow could be in the range of 12% to 22% or more -way more than in an unsecured business loan. Also, there are some other additional charges (like an annual fee or an over-limit fee) that you won’t find in an unsecured business loan.
Unsecured Business Loans
Unsecured business loans are a great option if you don’t want to put up collateral. But you’d need a great business credit score to get low rates.
If you have bad credit, you will either:
- Only get approved for business loans with a very high interest-rate
- Not be approved for any business loans, in that case, you might want to get a secured loan or try improving your credit
Camino Financial: Your Best Option
At Camino Financial we extend small business term loans that range from $5,000 to $400,000. Different from traditional lenders, we offer flexible and convenient terms:
- Our loans are unsecured, meaning they don’t require collateral. To evaluate your case, we mainly take into consideration your personal credit and the global cash flows of your business.
- We are open to extending finance options to borrowers with bad credit and only ITIN.
- You can use the funds for a variety of purposes: working capital, equipment purchases, and also to pay off personal loans or credit cards that had been utilized for business purposes. You can even use the loan to purchase a second business.
Also, our requirements are more flexible:
- To apply for a microloan your business should generate $30,000 in annual sales; to apply for a small business loan, your business should generate $90,000 annually.
- Your company should have been operating for just nine months.
When you’re ready to apply, these are the only documents you’ll need:
- Your online application.
- Electronic authorization to download the last 6 months of banking activity.
- Last year of tax returns with reported business income.
- Proof of business registration.
Last but not least, we application process is easy and quick. It takes minutes!
If you are ready to take the next step, all you have to do to start is submitting this loan application. You will receive an instant response informing you if you have been prequalified. In 24 hours one of our business loan specialists will get in touch with you to guide you through the borrowing process.