It’s a fact: to succeed in business, sometimes you need to borrow money to keep cash flow steady. But what do you do if you have bad credit? What business financing options do you have?
Not to worry. Even if your business and personal credit scores are too low to qualify you for traditional business financing, you still may qualify for a secured business loan with the right lender, also called a collateral business loan.
What is a Collateral Business Loan?
Collateral is an asset, which is anything of value that you can pledge against a loan. We’ll get into what can be used as collateral in the next section, but here’s what you need to understand about collateral and asset-based financing.
Having a high-value asset gives the bank something to take and sell should you not be able to pay off your loan. This reduces the bank’s risk, which makes it more inclined to approve you for a loan.
Here’s an example: let’s say you want to borrow $50,000 and you have equipment worth $85,000. You pledge the equipment as collateral and get the money. One day you realize you will never be able to repay the loan, and you default. The bank can then seize that equipment and sell it to cover what you owe. If the bank gets more than what you owe, they’ll keep that, too.
Generally, banks want collateral that is easy to liquidate, or convert to cash. It’s easier for lenders to offer you financing when the collateral is heavy equipment like dump trucks or semis that can easily be sold than it is real estate that may take months or years to sell.
Just like with any type of bank loans, you’ll be given repayment terms, and, assuming you make all your monthly payments on time, you’ll also build your business credit. See more on what it takes for a start up business loan here.
What is Used as Collateral for a Business Loan?
There are several categories of assets you can use for your collateral-based loan, including:
- Paper assets
- Hard assets
- Future earnings
- Personal assets
- Heavy equipment
A lender loves it when you have paper assets like cash, CDs, or stocks that can be used as assets against your loan. They are the easiest to liquidate.
Hard assets need to be sold, and their value is less determinate. This includes things like equipment, vehicles, buildings, and inventory.
You can also pledge future earnings as your guarantee. Your invoices and accounts receivable have a value, though it isn’t guaranteed that the lender can collect on them, so you may pay a higher annual percentage rate to get your money.
If you have none of the above in your business, you may be required to give a personal guarantee with something you own, like your car or home.
If you don’t qualify for a business loan without collateral, consider what you have to put up as a guarantee against the loan.
Collateral by Type of Business Loan
There are several types of collateral loans for small businesses, so find the one that best suits your needs. Some business lenders focus on certain types of loans, while others will offer multiple options. What they all have in common is that you will need to secure the loan with your asset(s).
In most cases, you will need to come up with collateral for an SBA loan. If your business lacks adequate assets, your personal assets will be considered. However, and this is important to know: SBA loan collateral isn’t always required. If your loan application looks good other than the fact that you don’t have assets, you could still be approved as a borrower.
Also important to note: the SBA collateral loan-to-value ratio is decided on by the lender, not the SBA. So one bank might determine the amount of money you are eligible to borrow as less than another does.
There are several types of SBA loans to consider, including:
- 7(a) loan
- 504 loan
- SBA Express loan
- Veterans Advantage loan
For banks, collateral is one of the 5 C’s, along with:
In addition to the bank loan collateral you put up, a lender at a bank will look heavily at your credit scores (check your free business credit scores so you know where you stand before applying).
As I said before, each lender may set your bank collateral loan-to-value ratio differently during the loan application, so be comfortable with the value you’ve been given before you agree to borrow the money.
Commercial Real Estate Loans
If you have equity in commercial real estate that you own, that can be used as your personal guarantee. It’s the same as if you took out a home equity loan on your house to use the money to remodel it: you use your commercial real estate loan collateral to get the funds you need to expand, build, or remodel your property.
The commercial real estate collateral loan-to-value ratio is determined by dividing the loan amount by the appraised value of the property. So if you have a building worth $1 million and want a loan for $600,000, the loan-to-value (or LTV) would be 60%. The lower the LTV, the better repayment terms and rates you can get.
Another option where you can use collateral to get credit is with equipment financing. Your equipment loan collateral is baked in: it’s the equipment you’re buying!
Because equipment depreciates quickly, the equipment loan collateral loan-to-value is often lower than with other assets at around 50%.
Many businesses opt to lease equipment because it loses its value so rapidly, so that’s another option to consider.
Another lending option with the asset baked in is the inventory loan. Let’s say you sell cars and want to buy 20 of them. That’s a lot of cash, but if you use those cars as inventory loan collateral, the bank will be satisfied and you can get the money you need to make the purchase.
Typically, your inventory loan collateral loan-to-value will be about 50-80% of the value of your inventory. Some inventory is easier for a bank to sell than others, so that will weigh into the value it assigns.
If you run a business that requires you to send invoices to customers, invoice financing might be a good fit. Your invoice loan collateral is the value of the invoices themselves: you borrow against the value of future-paid invoices. Once you get paid, you pay off your loan.
Another option is invoice factoring. Rather than you as the borrower managing your invoices, you essentially sell the lender your invoices and they handle getting them paid while also giving you the cash you need.
The invoice loan collateral loan-to-value ratio is typically 50-80% of the invoice.
Private Investor Loans
If you choose to borrow from a private lender, you may also be required to provide collateral. Because you’re not going through a traditional financing channel, the private investor loan collateral requirements may vary, as will the private investor loan collateral loan-to-value ratio.
Pros of Collateral Business Loans
There are many benefits you reap when you borrow money using collateral.
If your personal or business credit score isn’t all that high, you can still get the financing you need from a lender willing to offer you a collateral-based loan. If you aren’t sure what your business credit looks like, take a look at your business credit report.
If your credit history is low or nonexistent, taking out a collateral loan will help you build your credit so that you continue to get better and better terms whenever you apply for financing.
While cash flow loans, business credit cards, or merchant cash advance loans often have higher interest rates, because you’re putting up an asset with a collateral business loan, you can typically get better terms.
You also have high approval odds, assuming that loan-to-value is low. And, depending on the value of your collateral, you may be eligible to receive higher funding amounts
Cons of Collateral Business Loans
Though collateral small business loans can be right for many entrepreneurs, there are also drawbacks you need to be aware of.
The application process may be lengthy, in part because the lender has to assess the value of your collateral. And not all collateral can be used: there must be sizeable equity and value in the collateral you offer.
You’re pledging your assets as your personal guarantee, so you have the potential to lose what’s important to you.
Your business might receive a UCC filing as a result of taking out asset-based business financing. This is a legal notice filed with the Secretary of State that says that the lender has an interest (or lien) against the asset you’re using to get financing. This will show up on your credit report, and if not handled appropriately by the lender, could impede you from getting further financing down the road.
The cost could be higher than with traditional business loans, so if you qualify for one of those, that should be your first choice.
Your business can’t thrive without cash flow. If you need working capital, borrow money smartly. If you don’t qualify for other financing options because of your credit history, borrow against assets you already own.
This article was originally written on February 18, 2020 and updated on July 8, 2022.