Understanding Collateral

Understanding Collateral

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Bank loans are usually the least expensive way to finance a small business. However, it is not easy to get a bank loan as banks have strict standards for lending. As a general rule of thumb, it can be said that banks always demand the borrower to put up collateral for a loan. [Editor’s Note: It’s not explicitly mentioned here, but banks typically want the loan to be fully collateralized. Namely, if you are borrowing $100,000, you need to pledge $100,000 of collateral as appraised by the bank ] The only exception to this rule is for clients who have a long-term relationship with banks and whose business has proven to be profitable over a multi-year period.

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So collateral is important for banks as it reduces their risk. If the business is not able to pay back the loan, a bank may decide to take ownership of the collateral that has been pledged to them. The documents that you sign when you got the loan will allow the banks to do this. Usually the banks will not take ownership of collateral when you miss an interest payment or one of two repayment installments but they will once the bank feels that their loan is at risk.

Banks in general prefer to have collateral that they can easily convert into cash such as deposits, cars and real estate. Their advance rates against these assets will be higher than against inventory or receivables, which are much harder to convert into cash.

Banks will make their own assessment on the value of collateral— the banks consider the fair market value of an asset which might be much different (often less!) from what the business owner has paid for it. Therefore, it might be wise to have an independent appraiser give you an estimate on the value of your asset prior to going to a bank.

The advance rate is not fixed and fluctuates depending on the asset. So how much would you be able to get?

Clearly the best collateral for a bank is a cash deposit or cash savings. They will advance between 95% – 100% on this form of collateral since it is a very low risk for a bank. The bank should be able to give you very favorable terms for a loan based upon cash collateral. The disadvantage for the business owner is that in case of a default it is very simple for a bank to take ownership of the cash. Moreover, you will not be able to use this cash as long as it serves as collateral for the banks.

Investments such as bonds or shares portfolios can also serve as collateral. Usually the advance rate is lower than for cash as the value of shares and bonds fluctuates. This form of collateral is only used by large banks as smaller banks lack the sophistication to value bonds / shares.

Probably the most commonly used form of collateral is real estate, either a residence or a commercial building. Advance rates vary greatly depending on the quality of the real estate, location and marketability. Before the recession, banks were eager to advance up to 100% of the value of a residence either through a first mortgage and/or a home equity loan. The crash of 2008 and 2009 made clear that the value of real estate can decrease quite rapidly, which resulted in large losses for the banks. Now, in general, banks are much more conservative and will advance up to 70-75% of the value through a mortgage. Through home equity loans you can increase this advance rate somewhat. The same advance rates basically apply for commercial real estate, although in this segment location is even more important, and banks will consider the credit quality of the tenants.

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Cars are a good source for collateral. Credit unions have specialized in lending against cars and offer favorable terms. It is not uncommon that, for people with good credit ratings, a credit union will finance up to 100% of the value of the car at very(!) competitive rates.

Finally a very common form of collateral for small business is inventory and receivables. The advance rates on these assets vary greatly. With respect to receivables, banks will always exclude receivables older than 90 days and receivables to related parties such as the owner. Average advance rates of the eligible receivables will vary between 60% and 70%. With respect to inventory, banks are very conservative as they realize that they are usually not able to assess the value. Advance rates are around 50% – 60%, but could be even lower.

Documentation of the collateralized loan should not take that long as banks use standard documentation. What can take long is the appraisal of the underlying assets. Discuss this with your bank.

One last point: there is a relationship between the term of the loan and the underlying collateral. Short-term loans (less than 2 years) are usually covered by inventory/receivables and cash, medium-term loans (2 – 5 years) are covered by real estate or cars. Real estate is the best collateral for a long-term loan (> 5 years).

While talking to the banks about collateral, you have to keep in mind that the banks want you to have skin in the game. The first loss of a business should always be for the shareholder. Nevertheless, I encourage you to talk with banks or credit unions, as their rates are usually so much better than the rates of alternative lenders.

About the Author — Ronald Blok was the CEO of RaboBank N.A. from 2006-2013 and has worked in the banking industry for over 20 years.

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