What is collateral and do I really need it for a business loan?

Traditionally, collateral has been considered an important part of qualifying for a small business loan. In fact, it’s one of the Five Cs used by many traditional lenders to help them evaluate a potential borrower.

The term collateral refers to “an item of value used to secure a loan”. Traditional lenders, like banks, typically look for secure assets like real estate or equipment as collateral, although anything of value the lender can easily sell, to satisfy your debt should you default, might be accepted—depending on the lender. As per Finder’s list of collateral, lenders generally accept collateral in the form of:

• Real property. Most lenders are happy to accept both commercial and personal property, as real estate’s value often stays the same or increases over time.
• Equipment. Equipment loans use the equipment you’re buying to back your loan. Many lenders accept equipment as collateral on unrelated loans too.
• Inventory. The inventory you’re buying can serve to secure the loan. Your lender may require an auditor to appraise the value of your inventory before accepting it as collateral.
• Accounts receivables.Often accepted if your business’s cash flow is tied up in customer invoices. Many lenders like this type of collateral because it’s easy to quickly convert into cash.
• Cash. A cash-secured loan uses your business’s savings account as collateral. Your business is placed in a lower-risk bracket thanks to the highly liquid nature of cash as collateral. That low risk can mean a lower rate on your loan.
• Personal assets.For start-ups without many assets, your home, car, or investments can secure a loan. But take care: If you default, you risk losing your business and your valuable items.

Once your proposed collateral has been accepted, banks will determine the loan-to-value ratio of your collateral based upon the nature of the asset. In other words, you may be allowed to borrow, for example, 70 percent of the value of the appraised real estate or 60 to 80 percent of what they call ready-to-go inventory. Be aware, individual lenders consider the loan-to-value ratio differently, so you’ll need to ask your lender how they intend to set that value. It’s also recommended to have the assets you’re putting up as collateral professionally appraised to get an idea of how much you should expect from your lender.

Most traditional lenders require collateral with a small business loan, but there are other lenders who do not require a specific type or value of collateral to approve a loan.

A General Lien on Business Assets vs. Specific Collateral

Some lenders, including many online lenders, don’t require specific collateral, but rather require a general lien on your business assets (without valuing those business assets) and a personal guarantee to secure the loan. This may make qualifying for a loan easier and faster, depending on the nature of your business and your business assets.

In addition, because the loan is not based on the loan-to-value ratio of specific collateral, the lender is using other data points to evaluate a business owner’s creditworthiness. For example, by looking at the overall health of your business, your cash flow, and your personal and business credit profile, you might even qualify for more than you would with a traditionally collateralized loan.

By looking at the loan process differently, many lenders are making more capital available to small business owners who don’t have the required assets needed to collateralize a loan at their bank. Thus, a lack of sufficient business collateral doesn’t mean you can’t get a small business loan!