As an entrepreneur who is looking for ways to fund a business venture or idea, a secured loan may be the only funding option you have available to you. But before you pursue a secured loan, you need to be sure you have a firm grasp on the concept of collateral.
Guide to Understanding Collateral: Secured vs. Unsecured Loans
There are dozens of different ways you can fund a small business, but loans are among the most common. And if you’re going to pursue a loan, you must understand that there are two basic types of loans: unsecured and secured.
In the most basic sense of the term, an unsecured loan is a loan that isn’t backed by any specific asset or money. The lender extends the loan based on other factors – such as creditworthiness – and is essentially trusting that you’ll repay the loan.
“Because it’s much more difficult to reclaim money if you default on the loan, unsecured loans are much riskier than secured loans,” entrepreneur Bianca Crouse explains. “And as we all know, the riskier the loan, the more it’s going to cost you. Expect to encounter higher interest rates than you would get on a secured loan. And, as lenders won’t want to risk too much on you, expect access to less money overall.”
A lot of times, unsecured loans aren’t as unsecured as a lender would like you to think. Many lenders will require you to sign a personal guarantee. This guarantee states that – even if you don’t operate as a sole proprietorship – you are personally responsible for repaying all business debts.
A secured loan means there’s some kind of asset that’s capable of being seized in the event that the debtor can’t repay the business loan. The classic example is the mortgage. If a homeowner can’t pay off his mortgage, then the bank is legally able to repossess the house to account for any losses.
“Because it’s generally easier to get money back if something goes awry, secured loans are much easier to get,” Crouse says. “Because the loans are more secure (hey, that’s where the name comes from), they are considered less risky. As long as you have collateral equal in value to the amount of money you’re attempting to borrow, you can get a lot of money at very good rates.”
What Counts as Collateral?
Collateral is defined as, “Something pledged as security for repayment of a loan, to be forfeited in the event of a default.” When you pledge collateral, you’re getting a secured loan. This means you’ll likely have to give up a specific asset (or assets) if you default on the loan.
Lenders almost always want to get their money back in cash, so collateral is nothing more than an insurance policy. The last thing a bank wants to do is seize an asset and then manage/operate it or sell it. They’re in the business of lending money, not owning tangible assets that require time, effort, and expertise to manage. However, they care most about their bottom line. They won’t hesitate to grab some collateral when they have the right to it.
As noted, a house is the collateral for a home mortgage. So what counts as collateral for a small business loan? A lender will have to approve any sort of collateral you put up for a secured loan. Here are some typical (and alternative) assets that are frequently considered.
Real estate is one of the most common forms of collateral for large business loans. When you apply for a loan from a traditional source – like a bank – don’t be surprised if they ask you to put up some land or buildings. Just remember, you’re promising to give them possession if you default on the loan. If that’s not something you’re comfortable with, don’t sign the documents.
Perhaps you have the cash in the bank to cover the loan, but you’re borrowing because of the good terms and low risk. The bank may ask you to secure the loan with your own money. These types of loans are usually referred to as cash secured loans or passbook loans. They are extremely low-risk for the lender, which means you should get excellent terms.
If you’re obtaining a business loan in order to fund a purchase of inventory, the inventory itself can be used as collateral. This is quite common, but is far from a preferred method for lenders. They don’t want to end up with a bunch of inventory, which means you likely won’t get a great deal.
If you’re like the average small business, you have customers who don’t pay their invoices. In fact, it’s this restricted cash flow that may lead you to default on a loan. Ironically, these unpaid invoices may actually serve as a form of collateral for the lender. This process is known as invoice financing.
While most lenders don’t want to use equipment as collateral, it technically is something that can be leveraged as part of a secured loan. The equipment will need to be general enough – such as basic construction equipment, computers, or vehicles – so that there’s a large resale market. Expect less than stellar terms if you’re securing a loan with equipment.
Believe it or not, precious metals can actually be used to secure a loan (much like a savings account). Items like silver bars – specifically of the 1 oz, 5 oz, 10 oz, or 100 oz variety – are most widely used as collateral, though you’ll be hard pressed to find a bank to accept it. In most cases, hard money lenders are the only ones who will accept silver or gold.
4 Tips for Using Collateral to Secure a Business Loan
If you decide that you need a secured business loan, then you’ll want to begin doing some research on what options you have. Put some time into researching out how you can best protect yourself and your business.
Here are a few practical tips:
Try to Avoid Blanket Liens
If you run across something called a “general lien” or “UCC-1 lien,” you’re looking at a blanket lien. In essence, a blanket lien is a loan that gives the lender access to anything and everything they need to take in order to get their money back in a default situation.
While technically fair, you need to avoid blanket liens whenever possible. You could lose everything if you default, as opposed to just certain assets.
“In one sense, blanket liens are great, because businesses that wouldn’t normally be able to get loans can, and at a decent price,” Crouse notes. “Unfortunately, this type of collateral gives all the power to the lender. A business owner who enters into an agreement with a blanket lien risks losing quite a bit if they default on a loan.”
Keep Detailed Records
Any time you enter into the vetting process for a secured loan, make sure you have extremely detailed records. You might think an asset is worth a certain amount. You’ll probably be surprised by the value the lender places on it. They’re looking at fair market value and will probably offer you much less. They might even factor in a fire sale into their valuation.
The better your records are, the less likely that you’ll get “screwed over” on an asset valuation. Take your time, get your own appraisals, and carefully consider whether or not you want to offer up something as a part of a secured loan.
Put on Your Negotiation Hat
You don’t have to roll over and surrender when talking with lenders. You might not feel like it, but you have some room to negotiate a better deal. This is especially true if you’re a qualified borrower with a history of repaying debts on time, in full. If, on the other hand, you’re an unproven borrower with very little positive business credit, you probably don’t have much room for negotiation.
Consider Peer-to-Peer Lending
While most secured loans are asset-based loans, do know that you have alternative options. For example, many small businesses are ditching typical bank and SBA loans in favor of peer-to-peer lending. Hard money lenders – whether online or through your own professional network – are much less stringent and set their own rules. The terms might be stiff, but it’s possible that you can get a loan with less collateral requirements.
Don’t Limit Your Options
Whatever you do, don’t limit your options to a secured loan from a bank or other traditional lender. There are tons of alternative lending options. One good option is peer-to-peer lending. Iv’e found that some business owners get better terms with less risk.
A loan is meant to give your business access to resources that will allow it to grow. That being said, a poorly structured loan can also put you out of business if you aren’t careful.
Proceed with caution and get advice and opinions from as many different resources as possible prior to making a final decision.