What exactly is collateral?

by | Oct 21, 2021 | Business Finance | 0 comments

When you apply for a business loan, depending on several factors, including the loan amount, credit history, and the lender, you might be asked to supply collateral to secure the loan. Collateral is just assets that you pledge toward the loan. So, let’s say you default on the loan payments, now the lender can go after the assets pledged (a.k.a. collateral) to recoup their losses. This is why they like to see more liquid collateral, which can be quickly sold and thus converted to cash.

Not all loans will require collateral. And in some instances, depending on the lender’s policies, you may not need to pledge collateral if you have stellar credit. In this article, we look at what types of collateral small businesses often commit if they have to develop a way to secure their financing.

Some Collateral Basics

First off, understand that the lender is looking for minimal risk in reviewing your loan application. If you have a less than ideal credit history and are thus considered a risk, your loan approval odds go down. This is where collateral will generally come into play. Providing security for the loan (which a bank can turn into cash if you default) helps your odds.

Not every small company, however, has collateral. If you had something of value to sell, you might not need the loan in the first place, which is often how the thinking goes. Knowing what constitutes acceptable collateral can help you make some critical decisions moving forward as you pursue financing for your business.

Standard Forms of Collateral

1) Real Estate – This is a fairly common form of collateral to pledge. Especially if the loan is for the real estate itself, then it’s a no-brainer. The real estate being purchased will become the collateral on the loan. If you don’t make your payments, the bank or lender will seize the real estate and resell it to get their money back. You can also utilize real estate on other types of business loans. However, as a property can sit on the market for some time, this makes real estate not ideal for more liquid collateral.

2) Equipment – Again, if you purchase equipment and need a loan, the purchased equipment will stand as the collateral. The lender will proceed to sell it if you default. Some companies may opt to try and use the equipment for collateral regarding other loans. And yes, this is acceptable; however, it will come down to the value of the equipment and whether or not it can be quickly sold.

3) Stocks and Bonds – These are considered liquid and can be used as the collateral pledged to secure a loan. Retirement accounts are another asset that many try and use as collateral for a business loan. Whether or not you can engage a retirement account will depend on the terms and liquidity of the account in question.

4) Vehicles – Many business owners will use vehicles for their collateral. Vehicles are a popular collateral option. As with equipment, the lender will first have to assess the vehicles’ value and “resellability.”

6) Inventory – Often, inventory will be used as collateral for a loan in which the inventory itself is the item being purchased. So, much as with a real estate or equipment loan, the inventory will be seized and resold if you default on your loan payments.

7) Invoices – Some types of businesses often have to wait long periods for outstanding invoices. This leaves them short on cash and therefore scrambling to come up with the money to pay their bills. Construction, for example, is one such industry. If you have several outstanding invoices of more significant amounts, this could be a potential collateral source for securing a business loan.

8) Cash – What is more liquid than cash? If your company has cash reserves on hand, you can pledge this as collateral. This is the most readily accepted form of collateral, as a lender does not have to worry about reselling or collecting on past invoices.

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