There are forms of collateral that are more common than others, which are often associated with the loan type you choose. We’ve compiled the most common types of collateral that may be requested when applying for a business loan: real estate, cash, investments, blanket lines, equipment, inventory, and invoices.
Collateral is typically used as a way to mitigate risk to the lender in the event of loan default. In this case, the lender can seize the assigned collateral and sell it to help recoup its financial losses.
It is a common requirement when applying for financing and can come in many forms depending on the loan type. And while it is not always a requirement for all financing options, it acts as a form of security that can provide a borrower with better loan rates and terms in comparison to loans without collateral requirements.
1. Real Estate
For mortgages, the real estate being financed typically acts as the collateral to secure the loan. Essentially, the risk lies in losing the property if the borrower defaults on the loan, as the lender can take possession and foreclose the property. This form of collateral is also commonly used for personal loans and commercial real estate loans.
2. Cash
This is a simple form of collateral that basically allows a lender to recoup financial losses without selling off assets. Instead, the borrower offers a cash sum that can be called upon in the event of default. Documentation is usually simple, as you can demonstrate your cash source from your business bank account statements.
3. Investments
For businesses with stock, bonds, or other investments, these can be offered as a form of collateral. Similar to cash, this is a pretty straightforward collateral type, as investments are easily accessible and can be liquidated quickly.
4. Blanket Liens
A blanket lien allows a lender to seize multiple assets at once in the event of default. This type of collateral is considered to be quite risky for the borrower and should be used only when strictly necessary since you could potentially lose all of your assets that are housed under the lien contract.
5. Equipment
Most loans secured by equipment collateral are tied to some form of equipment financing. There are many types of equipment that can be applicable to these loans, including vehicles, heavy machinery, and office equipment. Keep in mind, equipment assets tend to lose value over time, so some lenders may require additional security.
6. Inventory
You can offer inventory as a form of collateral if your business has product offerings. Most commonly associated with retail-based businesses, inventory can be considered as collateral since the lender may be able to sell off unsold merchandise. The value may fluctuate, however, and may have varying requirements depending on the request of the lender.
7. Invoices
For businesses that issue an invoice or have accounts receivable, they may be able to partake in invoice factoring. Generally, this means selling off outstanding invoices to third party companies who will then seek repayment from your customer. Invoices aren’t typically used as collateral for business loans per se, but rather for businesses looking to shift debt and keep up with cash flow.
How Collateral Works
Generally, applying for most business loans will require some kind of collateral, whether it be property, equipment, cash, or some other form. The value of the collateral should equate to enough coverage that it can cover the loan and make up for any monetary losses in the event of default.
Lenders will decide what type of collateral is needed, and it usually reflects current assets of the business or the asset being financed. This will also determine the maximum loan amount to be provided, along with conditions of the loan agreement.
That said, valuation among collateral types differs depending on the loan type and asset. As such, there are a few considerations to keep in mind when valuing collateral. This includes:
- Collateral coverage ratio (CCR): This is a calculation that compares the discounted collateral value with the total loan amount. This is to ensure proper coverage and that the value of the collateral offered is capable of covering the loan amount in the event of default.
- Borrowing base: This is a value that represents the maximum loan amount a lender is able to offer a borrower. It’s calculated by multiplying the loan-to-value (LTV) by the value of the assigned collateral.
Common Collateral Requirements
Depending on the collateral type, there may be certain requirements imposed by the lender to ensure it’s a viable source of security that can back the loan. Here are some common collateral requirements to keep in mind:
- You’ll need to sign a lien agreement: A lien agreement allows the lender to place a position of power over the assigned collateral. Meaning, they have the right to secure the debt and seize it in the event of default. A common form of this is by filing a UCC lien.
- The pledged collateral will need to be of equal or greater value: Lenders will typically require the assigned collateral to be of equal or greater value than the loan amount provided. If necessary, this ensures that financial losses can be recouped once the assets are sold off.
- Determine how easy it will be to sell off the asset: Some collateral types are easier to liquidate than others. Lenders will take this into consideration when determining if they are able to sell the asset quickly enough to recoup any financial losses if the borrower were to go into default.
- The depreciation of the asset will need to be considered: Depending on the collateral type, some assets may either depreciate or appreciate in value. For example, equipment assets may lose value over time, whereas real estate assets may gain value over time.
Pros & Cons of Using Collateral for a Business Loan
| Pros | Cons |
|---|---|
| Can support an application for financing for borrowers with less than ideal credit or finances | May require additional paperwork, which can slow down the underwriting process |
| May allow for more favorable rates and terms when getting a business loan | Can potentially cause you to lose pledged assets if the loan goes into default |
| May provide the borrower with higher loan amounts or further financing opportunities | May come with strict requirements set by the lender that you may be ineligible for |
Benefits of Using Collateral
There are a few benefits to offering collateral to secure a business loan. Generally, it involves the opportunity for favorable loan terms for the borrower. Certain benefits may include:
- More flexible qualifications: With the provision of collateral, some lenders may be more lenient with other qualifying factors such as credit score, time in business, and annual revenue. While borrowers should aim to have strong credentials within these areas, it does offer some level of flexibility to the applicant.
- Lower interest rates and longer repayment terms: You may be able to negotiate better rates since you can use collateral to mitigate some of the risk when getting financing. Lenders will typically offer lower starting rates to borrowers with collateral to offer rather than those who don’t. Additionally, if you’re seeking a loan with a long repayment term, collateral can be used to offset the risk to the lender.
- Higher loan amounts: Keep in mind whether the collateral securing the loan will depreciate or appreciate in value over time. Depending on the value, you may be able to get higher loan amounts when applying for financing. That said, the collateral value typically has to be of equal or greater value than your proposed loan amount.
Downsides of Using Collateral
There are potential disadvantages to getting a loan that requires collateral. It typically involves the risk to the borrower and losing pledged collateral associated with their loan. Other downsides can include:
- Documentation requirements: Depending on the collateral type, there may be heavy documentation requirements as part of the underwriting process. Whether it be UCC filings, property records, etc., it may tack on time to the overall approval and funding process.
- Losing pledged collateral: The biggest risk for borrowers is the loss of their pledged collateral in the instance they default on the loan. If the lender is seeking repayment, they can seize the asset and sell it off to recoup their losses.
- Not all collateral will qualify: Sometimes, the collateral you can offer won’t be enough to cover the loan or is an asset that may depreciate in value over time. In this case, some lenders may require excess collateral, which means you may have more to lose overall.
Alternatives to Collateralized Loans
If you’re unable to offer collateral to secure financing, there are other unsecured loan types available as alternatives.
- Unsecured business loan: Not all business loans are required to be secured by collateral. Some lenders offer unsecured business loans if you can prove that you have strong credit and financial history, and these loans can be used to provide working capital for a wide range of business needs. Check out our top-recommended unsecured business loans to learn more.
- Unsecured line of credit: A business line of credit can have both secured and unsecured options. For borrowers looking for an unsecured line, you will have to demonstrate strong credentials and will likely be subject to higher interest rates and lower loan amounts. For more information, read our article on unsecured business lines of credit.
- Business credit card: Business credit cards can be used on an as-needed basis to make business purchases, and don’t typically require any form of security. As a revolving credit facility, you can utilize funds and repay and reuse them over time. You can check out our list of the leading small business credit cards to find one that may work for you.
- Merchant cash advance (MCA): An MCA may be applicable to businesses that need quick access to funds and have the ability to repay it quickly. While risky, it can help bridge gaps in cash flow or be used to cover emergency expenses. Typically, no collateral is required; however, this option is expensive and has high rates and fees. You can find a provider in our roundup of the best merchant cash advance companies.
Frequently Asked Questions (FAQs)
Collateral is not a requirement of all business loans. However, it can be requested by a lender to supplement the credentials of a loan applicant and used to secure the loan and mitigate risk in the event of default.
There are numerous forms of applicable collateral that can be used to secure a loan, and it typically depends on the loan type and requests of the lender. Common collateral types include real estate, cash, equipment, inventory, and accounts receivable.
Yes. However, the minimum value required will be defined by the lender and will vary depending on your financing needs. Generally, the collateral provided needs to be of equal or greater value than the loan it’s securing. This is in case the lender needs to liquidate the collateral to recoup losses in the event of loan default.
Bottom Line
Small business loan collateral is used to ensure that in the event of default, monetary losses are able to be recouped. There are many forms of collateral that can be used, and collateral will vary depending on your financing needs and the loan type you choose. The most common types of collateral include cash, real estate, equipment, inventory, and accounts receivable. Oftentimes, the collateral offered can be the asset you’re financing. That said, you can secure your loan with a variety of options and can work with your lender to determine what works best for you.
