If you’re thinking about expanding your business, you’re probably considering financing. In this case, you also need to consider collateral—small business loans are usually the cheapest type of funding, but you’ll need to put up collateral to secure these loans. Banks and other lenders decide on interest rates, loan amounts, and other terms based on the amount and type of collateral you have to offer them.
Collateral is an asset, such as cash or real estate, that a loan applicant offers to secure a loan as a guarantee that the loan will be repaid. The applicant agrees that the lender can claim the collateral if the applicant defaults on the loan.
Lenders want to lend money to people who have skin in the game for pretty obvious reasons—they want some way to get their money back in case you stop repaying your loan. Commonly, banks want small business loans to be fully collateralized, meaning you need to offer enough collateral to cover 100% of the proposed loan amount.
Different types of lenders accept various forms of collateral, so there are probably several routes you can take. It’s important to remember that there’s always a risk that you’ll lose the collateral if you default on your loan.
Collateral in the form of cash, as a deposit or in savings, will always be the gold standard for banks. It’s low risk for banks because it’s very easy to get their money back in case you default. While you’ll get the most favorable terms if you offer cash as collateral, you might want to shield your money from banks—you also won’t be able to touch the cash so long as it’s being used as collateral.
Real estate and home equity are the most commonly offered collateral for small businesses because a house is typically the most valuable asset an individual possesses. However, most banks will only take a small fraction of equity accrued on a house as collateral because they follow stringent debt-to-income ratios.
Along with homes, cars are common options for collateral. It’s best if you own your vehicle or if the total amount you owe on your car note is significantly less than its Kelley Blue Book value. Credit unions will often offer loans for close to 100% of the value of your car.
Like residential real estate, you can use commercial property as collateral. If you plan to buy commercial property with a loan, you can actually use the property in question as collateral. The same sort of financing is also available for expensive equipment.
You can leverage your 401(k) as collateral, but you might get hit with a large tax bill. Many 401(k) plans allow you to take a loan out at prime interest plus 1 to 2 points. Other investments can be used as collateral, but you will typically get worse rates than if you can offer cash.
Some lenders have options called asset-based loans that accept a small business’s inventory and accounts receivable as collateral. These loans will typically be smaller than when other assets are offered as collateral because it’s difficult for banks to determine the value of your inventory or accounts receivable. However, these can be good options if you don’t have a lot of valuable assets like real estate.
As a small business, you can apply for merchant cash advances, where you trade a portion of your daily credit card sales for a loan. While merchant cash advances are flexible, the interest rates are often high.
Before applying for any loans, think hard about the size of the loan your business requires and what you’re willing to put up as collateral. Traditional banks want their loans to be fully collateralized, but other lenders might be less strict. In those cases, though, the interest rates will usually be higher and the loan amounts will be smaller.
Don’t be afraid to negotiate with a lender based on alternative lending options, your credit history, and the value of your assets.
If you’re like many Americans without valuable assets, there are still lending options. You’ll want to seek out unsecured loans, which are lending products that don’t require collateral. Credit cards are the most common unsecured alternative to loans. Because the lender takes on more risk, the terms are generally far less favorable than a term loan from a bank—but you also don’t have to stake any of your assets.