When approaching a lender for a small business loan, a key factor that will come into play is collateral. Its importance is dictated by the type of loan you are looking to obtain. Collateral is something of value that is used to secure your loan. It is usually required by lenders as a way to safeguard the loan—to guarantee that they will not lose their money if you fail to pay it back.
Collateral is typically a valuable asset or property that is owned by you or your business that could be taken and sold if you were to default on the loan. In other words, collateral is basically a kind of insurance for the bank to guarantee some recourse if you default.
Different requirements for different loans
The specifics of collateral requirements vary depending on the type of loan.
Conventional Loans: Lenders enforce loan-to-value (LTV) and loan-to-cost (LTC) requirements. These ratios directly determine the maximum financing amount available relative to the collateral securing the loan. The value and quality of collateral largely dictates lending limits.
SBA Loans: The Small Business Administration takes a different approach. While collateral is still evaluated, business cash flow serves as the primary repayment source and determining factor. This means SBA lending capacity isn't necessarily constrained by collateral value alone, potentially allowing for higher loan amounts than conventional financing when a business demonstrates strong cash flow performance.
Why do lenders require collateral?
Lenders assess their risk by evaluating a borrower's overall personal and business profile, including the availability and value of personal and business collateral (e.g., assets, real estate, equipment, receivables, inventory), to determine creditworthiness. A credit risk is the possibility that a borrower will not repay a loan or meet the financial obligation to the lender. Banks and financial institutions must be meticulous when distributing loans to ensure that they can recoup their money.
They assess credit risk of a borrower based on what is commonly called “the 5 C’s.” These are character, capacity, capital, collateral, and conditions. In short, character refers to the borrower’s credit history; capacity refers to the ability to pay back the loan; capital refers to the borrower’s financial resources; collateral means assets to secure the loan; and conditions are the circumstances surrounding the loan.
Collateral is the most tangible component of these, and perhaps the greatest type of security for a loan’s repayment. Borrowers are more likely to repay loans when valuable collateral secures the financing, making lenders more comfortable due to its potential liquidation value.
How collateral works for an SBA loan
In contrast to conventional lending, loans backed by the SBA are dependent upon the cash flow of the business as the primary source of loan repayment, with collateral as a secondary option. The specifics of pledging collateral for an SBA loan depend on your lender and financing request. Certain collateral requirements need to be met depending on the loan product, size and use of funds. Learn more about how Live Oak Bank views collateral in this blog post.
Types of collateral for a loan
There are several types of assets that can be used as collateral. These include:
- Property or real estate, such as buildings or land owned by you or your business
- Vehicles—automobiles, trucks, vans, farming vehicles, etc.
- Machinery, manufacturing equipment, tools, office equipment, etc.
- Goods or inventory
Intangible assets may also be used. These include:
- Accounts receivable
- Any stocks or investments you or your company may have
- Business Goodwill
How collateral works
Lenders will typically want collateral that is equal to (or even greater than) the value of the loan. Lenders use the loan-to-value (LTV) ratio to gauge loan risk and inform their lending decisions. LTV indicates the percentage of an asset's value a lender will finance. A higher LTV signifies greater risk for the lender, as it reduces their potential to recover the full loan amount through liquidation. Lenders will also consider the ease or difficulty in divesting the assets if needed. They would rather use collateral that is easier and quicker to sell in order to recoup their money.
Once you have established the value of your collateral and the terms of the loan, you will be required to sign a lien agreement for your collateral with the lender. A lien is a legal claim against your business’s assets. The agreement will be part of your business loan’s closing documents. A lien agreement states that you give the lender the right to take the asset if you default on the loan. It will also establish at what point the lender can seize the collateral.
The collateral will continue to be owned by you or your business during the life of the loan as long as you continue to make payments. If your business begins to miss payments, the lender will notify you of its intention to seize the assets.
Once you have paid off the loan, you will be issued a release of lien, which is a document stating that the loan is paid in full, and the lender is releasing its right to the lien against your business’s assets.
In conclusion, if your business needs capital for growth, offering collateral for a loan can be a prudent strategy for achieving financially sound expansion.
