For business owners who need capital to fund working capital or to invest in new projects, debt financing offers a convenient way to access significant amounts of capital without sacrificing equity in the business.
However, if a business goes into default and can no longer make interest payments, then the lender may move to take any existing collateral from the borrower as compensation.
What Is Collateral?
To understand collateral, you should first understand what lenders want from their investments. Banks and other sources of credit want a guaranteed ROI on their investment capital.
However, debt entails a degree of risk on the part of the lender. Businesses frequently run into economic headwinds, fall behind on interest payments, and ultimately cease operations.
In return for taking this risk, lenders often prefer that business owners put forward assets that, should the business file for bankruptcy, can compensate the lender for losses.
Why Some Business Loans Require Collateral
Not all business loans require collateral, but for business owners who want to enjoy the benefits of lower interest rates or for whom lenders identify a higher degree of risk, banks may demand it.
Federal government regulations around some types of SBA loans also include collateral requirements, though for private loans the lender will have discretion.
The Differences between Secured and Unsecured Loans
Secured loans, as their name implies, require security or forfeitable assets. Unsecured loans, in contrast, require no collateral.
A common example of a secured loan is a home mortgage. With a mortgage, debtors will forfeit the actual real estate should they fall behind on repayments.
Credit cards offer a relatable example for unsecured debt. With a credit card, the issuing bank typically does not require any collateral. Individuals may spend up to the credit limit with only the backing of their promise to repay the debt.
Secured and unsecured business loans work much the same way in principle. Treat a secured loan like you would a home loan.
Related: Difference between a secured and unsecured loan
Collateral for Small Business Administration (SBA) Loans
SBA loans come in several varieties and have varying collateral requirements. The exact loan amount depends on the needs of the borrower as well as the specific SBA program.
7(a) SBA Loans
7(a) loans comprise the majority of SBA loans. Businesses have discretion in how they deploy funds raised from a 7(a) loan, including working capital investments, capital expenditures, and even refinancing.
Some businesses may choose to use their 7(a) funds to purchase inventory, while other businesses may prefer to use the proceeds for financing new equipment.
The SBA does not stipulate that businesses provide any collateral for 7(a) loans up to $25,000.
504 SBA Loans
For longer-term debt arrangements, the SBA provides the 504 loan program. 504 loans do not have the same versatility as 7(a) loans. The SBA requires that businesses use funds from 504 loans for large-scale capital expenditures rather than working capital.
For 504 loans, the property itself often acts as the collateral, though some lenders may require additional collateral to underwrite the loan.
For businesses just getting started, the SBA microloan program may offer a convenient way to access small amounts of debt capital.
SBA funding intermediaries who underwrite these loans often require collateral.
Collateral for Conventional, Non-SBA Loans
Unlike SBA loans, conventional loans have non-standard requirements. The lender may use their discretion to determine whether a business owner should put up collateral.
For example, one domestic bank offers both secured and unsecured loans. In return for collateral, this bank offers a correspondingly lower interest rate as compensation for the risk the business owner incurs.
Interest Rates and Collateral
Lenders choose interest rates based on several factors, including:
- Free cash flow that is available after the business pays all operating expenses.
- The personal creditworthiness of the business owner. Bad credit on the part of the business owner can reduce the likelihood of receiving financing.
- The type and length of the loan.
Secured loans generally have lower interest rates than unsecured loans since the lender can feel more comfortable taking a risk when the debtor pledges collateral.
Small business owners should also remain cognizant of the fees involved in originating a loan.
Frequently Asked Questions
While some banks require a personal guarantee from borrowers, others may at their discretion allow lenders to offer alternative forms of collateral such as working capital.
What Are the Valid Types of Collateral?
Banks will stipulate the types of collateral they would accept in return for underwriting a loan. Some forms include personal assets such as your home or business assets such as inventory.
What Happens If You Don’t Have Collateral for an SBA Loan?
Generally, a lender will not provide capital to you if you fail to pledge collateral for secured loans. If your business has sufficient assets and cash flow, the lender may offer you an unsecured loan.
How Much Collateral Do I Need?
For SBA loans, lenders prefer to secure 100% of the loan principal as collateral. In other words, the value of the collateral must equal the value of the loan.
The collateral value of the secured assets are based on the salability in the open market and range between 20% & 80%. For example, owner-occupied residential, apartments, commercial buildings and vacation homes are valued at 80% of appraised value, undeveloped land at 50%, new equipment is up to 50% and used equipment, accounts receivable, inventory, etc is up to 20%.
As an example, if you ask the lender for $125,000, then the lender will usually ask for $125,000 in collateral.
Can I Use My House as Collateral for a Business Loan?
The bank will first go to the collateral value of the business assets. If those assets are not enough to secure the loan, they will go to personal assets to use as collateral. If your primary residence has less than 25% equity (equity is the amount an asset is appraised for versus what is owed) it can’t be used.
Next Steps in Applying for a Business Loan
The next step in applying for a small business loan involves deciding which bank or alternative lender you want to work with. Commercial lenders include banks, credit unions, and fintech lending platforms.
You can also search for lenders on the SBA website. This resource can connect with you all the SBA programs described previously, including 7(a) and 504 lending programs, as well as guide you through the application process.