What collateral types can be used for a business loan?
Basics of collateral for business loans
- Lenders take on less risk with a secured loan, thus it typically carries lower interest rates and higher amounts.
- Business loans can be secured with fixed assets, current assets, liens, an owner’s personal guarantee or a combination of collateral.
- Secured business loans give the lender the right to seize and liquidate certain company assets in case of default.
Risk is the driving factor behind all loan originations; lenders aim to mitigate risks when they loan money. Instead of a handshake and a promise to repay the loan, lenders often require you to offer up some kind of collateral.
Every loan falls broadly into the category of secured or unsecured. An unsecured loan is not backed by any physical or financial assets. Secured loans are backed by collateral, a pledge from the borrower to hand over certain assets if they default on the loan. Loans are typically secured against fixed assets, current assets, liens, a personal guarantee or a combination of those.
Fixed assets — also known as capital assets — are the most common type of collateral used in a secured business loan. It can be real estate, equipment, vehicles and other property that the business owns. Securing a loan against fixed assets allows the lender to take ownership of the property should the borrower default on the loan. This reduces the risk for lenders – they can recoup their losses if you default – but puts the borrower at risk of losing assets essential to business operations.
Current assets — also known as short-term assets — are a business’ inventory: cash, accounts and notes receivable, invoices and non-physical assets, such as investments. In terms of collateral, lenders view current assets as more liquid than fixed assets, meaning they can retrieve their money more quickly if you default. Borrowers benefit from using current assets as collateral as they are able to retain fundamental fixed assets in the event of a default.
First and second liens
Liens give the lender the legal right to seize specific business assets if a borrower defaults on their loan. While a lien can be filed on an individual asset, it is common to see blanket liens that comprise all of a business’ assets — both fixed and current. As the most comprehensive collateral option, it is risky for borrowers who could potentially lose their entire business.
Lenders file a Uniform Commercial Code (UCC) lien with the Secretary of State where the business operates to formalize the lender’s claim on an asset and create a public record of it. The UCC is a legal code adopted by each state legislature and aims to standardize certain business and legal transactions. Lenders are required to file UCC liens against assets in case other lenders wish take out a second lien, meaning they file their own liens against the same assets.
More than one lien can be filed against the same asset. The lender with the first lien position has the primary claim on the asset should the borrower default on their loan. A lender with a second lien position has the secondary claim, making it a riskier product and typically subject to higher interest rates. Lenders may be unwilling to take a second lien position, particularly following a blanket lien, as there is higher risk of the collateral being liquidated in full for the first lienholder.
Liens are often included in the fine print of a loan contract and easily overlooked by the borrower. Lenders are not required to notify a business it is filing a lien against, so it is wise to periodically check the Secretary of State public records where your business operates for lien activity in relation to your company and ensure they are accurate.
Using personal collateral for a business loan
If a company lacks sufficient credit or resources for collateral, a business owner may have to secure personal assets against a business loan. Personal assets do not replace business collateral. However, when combined with fixed or current assets or a lien, personal collateral can influence a lender’s decision. You can decide what assets to provide as a personal guarantee, such as a home, savings and retirement accounts, or sign an unlimited personal guarantee that grants the lender access to the entirety of your personal assets.
Collateral and interest rates
Secured loans are based on the value of the collateral and give the lender more confidence in extending credit, consequently allowing them to offer lower — typically fixed — interest rates. By contrast, an unsecured loan puts the lender at higher risk of losing their investment in the event of a borrower default. Thus, unsecured business loans are difficult to qualify for, as many small businesses cannot sufficiently demonstrate to the lender that the loan will be repaid. Even for businesses that qualify, unsecured loans tend to carry high interest rates to reduce the lender’s risk. In a way, the revenue from high interest payments “secures” an unsecured loan. Lenders will only extend loans that they are confident will be repaid, either through agreed monthly payments, asset liquidation in the event of a default or — in the case of high-risk unsecured loans — alongside hefty interest rates.
Compare business loan lenders and identify whether they will file a lien against your business or require personal guarantees. A well-capitalized, consistently profitable company may find it worth putting fixed assets on the line to obtain capital. For fledgling companies, it may be more prudent to use current assets as collateral or opt for a higher-rate unsecured loan. Ultimately, the right loan for your business depends on how confident you are in being able to repay your debt.