Using Collateral to Secure a Small Business Loan

If you’re seeking a loan to fund your small business, it’s important to know that nearly all lenders will require some form of collateral from you to secure the financing in order to minimize their risk and recoup their losses in the event that you default on the loan. While it’s common practice, it’s still important to understand all of the risks up front before seeking out funding that requires collateral.

What Is Collateral?

Collateral is defined as an asset that a lender accepts as security for a loan or other obligation. While this can take many forms, it’s important to note that there are two types of collateral: those assets that you own outright, and those that you have a loan against (for example, a mortgage on your house). 

The best asset to use as collateral will have a title of ownership attached to it — like a home, motorcycle, or watercraft. Land cannot be used as collateral, however.

The specific type of collateral required depends on the loan type. For example, for a standard small business loan, real estate is often used, but for equipment loans, the equipment is its own collateral.

Business inventory can also be used if you’re using a loan to purchase more, but lenders may be wary to allow this, because in the event you’re unable to sell your inventory, they will likely question their ability to as well and might not be able to recover the money they lend you.

There are other possibilities, including cash savings or deposits. Banks will typically always accept this option since it presents low risk to them and on the plus side, they often have the lowest interest rates attached. However, the obvious disadvantage is that you have the potential to lose this money if you default on the loan. In some cases, you can use accounts receivable, though this is not common for banks due to the potential difficulty of authenticating purchase orders.

How Much Collateral Do I Need?

Generally, collateral amount is determined by what’s known as the “5 Cs:” that’s credit history, capacity for repayment, capital, collateral type, and conditions (interest rate, loan terms, and loan amount). These take into account both the applicant’s financial health and the specifics of the lender’s requirements.

Before You Commit to a Loan That Requires Collateral…

Be Aware of the Risks

Putting up collateral like your home or car is a serious decision that shouldn’t be taken lightly, so make sure you are prepared to handle this worst-case scenario before closing on your loan. While not necessary, it can help to consult a financial advisor beforehand to determine your risk aversion.

Retain Your Records

One major problem business owners encounter is that they tend to overestimate the value of their collateral in comparison to banks’ more conservative market value assessment. If you don’t have a general idea of your assets’ worth, it can be helpful to consult an independent appraiser before applying for a loan, but you should be keeping track of all of your assets regardless. You don’t have to get super complicated — even a simple Excel spreadsheet with line items of all of your purchases clearly documented should be sufficient.

Negotiate If Possible

You may not always have this option depending on your financial standing and credit history, but if you qualify for a small business loan, you should be able to work out specific terms and conditions that make sense for your situation. It’s common — and often recommended — to compare rates from different lenders to find the right fit.

Consider Alternative Options to a Loan

If a small business loan isn’t feasible or preferable for you, there are several other avenues to explore. There are home equity loans and home equity lines of credit (HELOCs) that allow you to use your home equity to access cash to fund your business. However, with both of these options, your home is used as collateral. HELOCs in particular usually have variable interest rates, meaning you won’t have a consistent monthly payment.

A business line of credit is another option that allows you to tap into funds and doesn’t necessarily require collateral if you have what’s considered an “unsecured” line. You have a draw period, or a specific number of years that you can tap into the funds. But with unsecured loans and credit lines, interest rates are typically much higher than those that require collateral.

Peer-to-peer lending is another emerging option that, as the name suggests, allows business owners to secure money from another individual. The often web-based formats of these lenders can make it a bit easier to get a competitive rate. The process is fairly straightforward: you share some information about your desired loan amount and business, and if accepted, you’re listed as an option for potential investors.

Finally, if you want to use your home equity to fund your small business without monthly payments, you may want to consider a home equity investment. While your home is the collateral with this option, you receive cash in exchange for a share of its future value. Plus, you can use the funds for anything you need them for: equipment, expansion, marketing, or whatever else you’d like.

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