There are two basic types of loans: unsecured loans and secured loans. An unsecured loan is made without any collateral to back up the loan. Your signature, as the business owner or authorized representative of the company, is all you need to obtain an unsecured loan once you’ve been approved.
A secured loan is backed by some form of collateral. Real estate, equipment, accounts receivable, future credit card receipts – all can be used as a guarantee that supports or “backs” the loan. The item(s) pledged to support the loan is a guarantee that the loan will be repaid – even if the lender has to sell the collateral to receive payment.
For lenders, unsecured loans are riskier than secured loans for obvious reasons. An unsecured loan is based on good faith and a good credit history, with nothing else to back it up. For that reason, unsecured loans have higher interest rates and less flexible terms.
An example of an unsecured loan is your credit card, which is backed solely by your credit and payment history. In this case, the credit card issuer/lender is compensated for the higher level of risk it takes with a high interest rate on your outstanding balance, coupled with fees such as late payment fees and annual card fees. Backing a loan with collateral – assets of some kind – keeps interest rates lower and costs down. Putting up collateral is often the difference between getting and not getting business financing when you need it.
Business lenders evaluate the soundness of a business loan based on the risk-versus-reward equation: the higher the risk, the higher the interest rate, or reward to the lender. Business loans are based on an evaluation of company and personal credit histories, financial history, cash flow, business growth potential and other indicators of the overall health of the business.
The stronger your financial case and the longer you’ve demonstrated you’re a sound credit risk, the less collateral you’ll need to tie up to support a business loan – a fine reason to keep a spotless credit history.
The Advantages of Collateralized Business Loans
When you put up collateral to back a business loan, you assume some of the risk associated with lending money – the risk that the borrower (you) may be unable to repay the loan. Your company’s assets, from property to machinery to inventory and accounts receivable can be used to secure financing for your business.
As a business owner, you can use collateral-based financing to fund a wide variety of business objectives like growth, acquisition, expansion, or even to generate working capital. Collateral-based financing is particularly useful for small companies and start-ups that lack a long-term credit history.
By taking on a greater portion of loan risk, you receive numerous benefits:
- A lower interest rate means you spend less for the money you borrow.
- By putting up your invoiced accounts receivable as collateral you can negotiate better terms, including length of payback, payment milestones and options to renew the loan on your say-so.
- Collateral provides more clout – leverage – during negotiations for a collateralized loan.
- Assuming a greater portion of loan risk and making timely payments builds a positive credit history, simplifying the process of securing another loan 24 months down the road. You look good to lenders.
How Collateral Works
Collateral-based loans are simply term loans with regular, periodic payments of both principal and interest that, within a defined time frame, retire the debt. The term of the loan is usually based on the “life” of the asset backing the loan. A loan backed by real estate can have a longer term than a loan backed by a piece of equipment that depreciates in value each year.
When Is Collateral-Based Borrowing a Good Business Strategy?
It’s ideal for start-ups that don’t have a credit or business history. Some entrepreneurs use their homes as collateral to access capital to finance a start-up business. “Betting the ranch” is a potentially risky decision that requires careful thought before proceeding.
Companies that are growing rapidly are excellent candidates for collateralized loans. These businesses need expansion capital to move into new markets, hire more staff, improve the office or expand product and service offerings. However, because these up-and-comers don’t have a long credit history, collateral greases the wheels and often provides the working capital needed to keep growing.
Companies with high levels of debt are also excellent candidates for collateralized business loans. These businesses often experience choppy cash flow, late pays and a seasonal impact that slows business growth. Putting up your book of cash receivables as collateral makes lenders more comfortable with existing, high levels of company debt – especially if that debt is unsecured.
Companies that are struggling financially are almost always required to back a business loan with something of value. Companies that experience financial ups and downs are riskier investments in the eyes of lenders but putting up collateral and assuming some of the risk usually makes the difference in landing a much-needed loan.
The Risk of Collateralized Borrowing
The biggest drawback of collateralizing a loan is the risk of losing your collateral, so it makes good sense to work the numbers six ways from Sunday to make sure your business has, or will have, the resources to keep current on monthly payments.
Pledge your company-owned office building to secure a loan and you could lose some valuable real estate and your business – a double whammy.
Another drawback to collateralized borrowing is that you tie up your assets. You can’t sell assets that are pledged as collateral until the loan is paid in full, which could limit your expansion options. So careful planning is a given before applying for a collateral-backed loan from your bank or other lender.
Sources of Collateralized Financing
Most businesses that want to expand have to borrow money at some point. You have lots of loan sources when you put up assets and assume some of the loan risk.
Start with your local bank. They know you, the process is simple and straightforward and many banks want the opportunity to invest in community growth – and that works to your company’s benefit.
Consider Using a Factor. A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts receivable. The interest rates charged by factors are often high but they’re an excellent source of capital for companies with lots of past due accounts and slow pays. Factors are also creative when it comes to structuring a collateralized loan. These lender-investors see value where traditional lenders may not.
Family and friends are sources of business capital, especially for start-ups. However, in these cases, a deal gone sour may strain a friendship or family relationship so be careful when borrowing from people with whom you have a personal relationship. Business and friendship aren’t necessarily a good combination.
Business lending all comes down to risk versus reward for lenders – the lower the risk, the better the terms and interest rates. But weigh this option carefully. When you assume loan risk you want to make sure that loan is paid promptly and in full.