What Is Collateral? How to Secure a Small Business Loan
Starting a business isn’t always cheap. While some opportunities allow you to earn with low startup costs, following your passion can sometimes require far more financial support. For many entrepreneurs, a business loan is necessary to get the ball rolling. Before you apply for your loan, you need to know the answer to one question: What is collateral?
Getting a business loan can be a tricky process, but understanding your application can boost your chances of success. Whether you need to borrow to build your inventory, hire talent, or rent office space, keep reading to learn what collateral is and how it can affect your company.
What Is Collateral?
Collateral is an asset or property you own that you promise to provide your lender in the case that you’re unable to pay back your loan. It basically serves as a backup, so your lender won’t be left with nothing if your business fails or you’re otherwise unable to make required payments. Plus, it’s insurance against the minority of people who attempt to take advantage of a potential free money opportunity.
Businesses may accept specific types of collateral and will likely include the required value of the collateral in your contract. However, examples of collateral in general may include:
- Real estate, including houses and office buildings
- Business inventory and equipment
It makes sense that banks and credit unions would require collateral. Loans frequently involve large sums of money, and even with collateral, they may still be taking a risk. After all, the reason you’re applying for a loan is likely because you want to start a business with no money or not enough money to invest.
Once a borrower promises collateral, a bank can seize that asset after the borrower defaults on a loan by missing payment periods or not fully repaying after a given period of time. That said, make sure you’re committed to paying back borrowed funds or willing to risk an important asset or assets before you enter a loan agreement.
Types of Loans That Require Collateral
Collateral affects a wide variety of loans, from home mortgages to secured personal loans, but in this section, we’ll focus on a few types of business loans that require this form of insurance.
Small Business Administration (SBA) loans are one of the most common types of loans taken out by business owners. This is because you can potentially take out millions, depending on your needs and estimated ability to repay the loan. Plus, they’ll probably provide the lowest interest rates out of any loans you apply for.
SBA loans are offered by banks, nonprofits, and other lenders, but they are guaranteed by the SBA, which requires collateral to ensure their money is safe. However, the SBA rarely expects you to repay everything in a short period of time, so your business will have a relatively lengthy safety net before collateral would be seized.
Car loans are technically a type of loan for consumers, but we’ve included this category in the list because of the rise of ridesharing gigs. Uber drivers and Lyft drivers traditionally use their own vehicles to drive passengers around the city, which means you need to obtain a personal vehicle before you can earn.
Auto loans are a great option for anyone seeking to become an independent contractor for a rideshare company, as they’ll provide the funds you need for your biggest startup cost. With your vehicle purchased, you can start earning as soon as you and your vehicle are approved for your selected platform.
If you choose to take out an auto loan, the vehicle you use the funds to purchase usually becomes your collateral.
For some businesses, the equipment needed to even function as a business can be the most expensive cost. This specific type of business loan would help you purchase things like large kitchen appliances or warehouse machinery.
As with car loans, the equipment you purchase with your equipment loan automatically becomes your collateral. However, keep in mind that interest rates can be pretty high if you expect your purchased equipment to be outdated quickly. This is because the worth of your equipment won’t adequately insure the cost of the loan.
Getting Business Loans Without Collateral
Collateral loans are known as secured loans because of the insurance it provides the lender. However, unsecured loans that do not require any form of collateral do exist. One of the most popular examples of an unsecured loan is a student loan.
While most financial institutions avoid giving away unsecured loans to business owners, there are some that you may qualify for. Two of the most common include:
- Credit cards: Like your personal credit card, a business credit card allows you to spend what you need (to an approved maximum) and repay only monthly minimums if you don’t have funds quite yet. Interest rates are typically high, but it’s a great solution for smaller expenses.
- Lines of credit: Much like a credit card, a business line of credit allows you to use as much as your approved credit limit, with interest rates only affecting the money you’ve taken out. You usually have to pay additional fees and have a fairly good credit score.
However, even if your standard business loan doesn’t require collateral, you may want to consider providing it as a form of goodwill. This is because collateral can help you claim lower interest rates. In addition, if you have bad credit or are a low-income applicant, collateral can improve your chances of getting approved for a loan.
Frequently Asked Questions
Understanding what collateral is will help you make the best business decisions possible, especially when you’re taking out a large sum of money in loans. Before you apply for your small business loan, read our answers to three common questions:
1. Does my collateral for my small business loan need to be owned by my company or me personally?
For newer businesses, where the company doesn’t have much worth, collateral is almost always owned by the business owner. However, if your business has gathered enough assets to act as collateral, you may choose to provide business-owned collateral to avoid getting things like your home taken away in the worst case scenario.
For loans that specifically help you purchase business assets, like equipment loans, those assets will both be owned by your business and act as your collateral.
2. Will collateral loans affect my personal credit score?
Yes and no.
Within the application process, your personal credit score will typically be affected if you are being considered for final approval. This means that your credit score won’t take a hit if you’re simply asking for a quote, or if you’ve received pre-approval for a loan. However, if you’re serious about taking out a loan, most lenders will perform a hard inquiry that will impact your credit score. This makes it important to be committed to a loan before freely applying.
Beyond the application process, there are ways to limit the potential impact of business loans on your credit score. The easiest is to form an LLC instead of doing business as a sole proprietor. Doing so makes you a separate entity from your business, which adds an extra layer of protection. In the event that your business is unable to repay the loan, your credit score won’t take the major hit.
3. What is the difference between collateral and a personal guarantee?
If you’ve considered or have taken out loans before, you may have heard of the term “personal guarantee” as a requirement in place of collateral. A personal guarantee is basically a written promise that you’ll be personally responsible for debt if your business is unable to pay back a loan. On the other hand, collateral requires specific items. You’ll typically see collateral as a requirement when you receive or apply for higher-cost loans, as risk is decreased if a lender knows exactly what assets you have to secure the loan.
Get the Loans You Need to Launch
Collateral isn’t purely a tactic lenders use to receive money in the event of a failed business. It’s also something you can provide to increase your odds of receiving critical funds at a low interest rate. By promising to take responsibility, you gain the trust of financial institutions who are helping you launch your businesses.
Once you have your loan secured, learn how loan amortization can help you pay off your business debts.