If you’re a small business owner, you might want a loan to help finance your company. Securing a business loan is not easy. You might need to offer collateral to get the loan application approved. What is collateral?
What is collateral?
Collateral is an asset or piece of property that a borrower offers to a lender as security for a loan. If the borrower fails to pay the loan, the lender has the right to take the asset used as collateral. Loans that are backed by collateral are secured business loans.
In general, collateral loans have lower interest rates than unsecured loans. The risk of default taken on by the lender is also lower with secured business loans. And, the borrower is more likely to repay the loan if they know they could lose their collateral.
Unsecured loans do not use collateral. An example of unsecured lending is a business credit card. Borrowers do not offer collateral when using a credit card. Since the loan is unsecured, credit cards typically carry higher interest rates.
In some cases where the borrower has great credit, collateral is unnecessary. The borrower’s personal guaranty, income, and credit history are enough to secure a loan.
Having no collateral in your loan agreement is rare. In general, a lender will require you to offer collateral. One big reason lenders prefer collateral is that they can lien the property. The lien is created when the asset is registered as collateral. But, it doesn’t go into effect until the lender shows that the borrower has been delinquent.
The advantage of secured loans is that they often have lower interest rates than unsecured loans.
But to get that better interest rate (or sometimes any loan at all) can be risky; if you are unable to pay off your loan as scheduled, the assets you used as collateral will be seized and sold, and the money raised by selling the assets will be used to repay the loan.”
—Susan Ward, Business Writer and Experience Entrepreneur
Examples of collateral
You can use many kinds of property as collateral for a business loan. Remember, if you don’t make the loan payments, the lender has the right to your property.
The business collateral can be a tangible or intangible asset. Tangible assets are physical items that can be seen and touched. Here are some examples of tangible assets you could use as tangible collateral:
Intangible assets are items of value that you cannot see or touch. Some examples of intangible assets include:
- Investment funding
- Payment rights
- Copyrights and small business trademarks
- Accounts receivable
Many businesses pledge their accounts receivable as business collateral. Accounts receivable lists the money owed to your business for the products and services you provide.
What is the purpose of collateral?
What is the purpose of collateral, and why do lenders require collateral assets in the first place?
Collateral serves as insurance for the lender if the borrower fails to pay. Collateral is also an incentive for the borrower to meet their payment obligations. While collateral helps you get your application approved, it is not enough to secure a loan. That is because collateral is the secondary source of payment for collateral loans.
The lender’s primary security is the signature of the borrower on a loan agreement. This signature states that the borrower will pay a specific amount over a period at regular intervals until the full value of the loan plus interest is paid.
Fair market value
Lenders and borrowers should consider the fair market value of business collateral. Fair market value is the selling price of an item that both the seller and buyer agree on. An item’s fair market value is different from its book value, which is the value of an item as it is listed in a business’s books.
The fair market value of the collateral is typically higher than the loan amount. The lender anticipates additional costs in seizing and liquidating business assets. The extra expenses might include a liquidation delay, transportation, or sale fees.
Tips for getting business collateral loans
Collateral is only one factor considered in a loan application. Your ability to make payments and your credit history also determine the loan amount.
With small business loans, management experience and equity investment also come into play. You will need to show your books to lenders. Keep financial statements to show loan officers the financial health of your business.
Do you need a simple way to keep track of your business’s transactions? Patriot’s online accounting software is made for the non-accountant, and you can complete your books in a few simple steps. We offer free, USA-based support. Try it for free today.
This article is updated from its original publication date of April 11, 2017.This is not intended as legal advice; for more information, please click here.