What is a collateral loan? A full guide to secured loans

A collateral business loan is a type of financing where a business offers assets – known as collateral – to reduce the lender’s risk. Collateral can include real estate, equipment, inventory, or other valuable business assets. Securing a business loan with these assets provides assurance to the lender and helps offset any potential losses if the loan isn’t repaid according to the terms.

In some cases, offering collateral can result in more favorable loan terms, such as lower interest rates or higher borrowing limits. However, if the business does not meet the loan’s terms, the lender may have the legal right to seize the collateral to recover outstanding debt.

Assets used for a collateral business loan are typically expected to:

• Be owned by the business or loan applicant
• Have a high loan-to-value ratio (meaning the asset’s value is close to the loan amount)
• Be tangible or easily convertible to cash
• Not be pledged as collateral for other loans.

How collateral works in a business loan

In a business loan, collateral assures lenders that they’ll have assets to recover losses if the borrower is unable to repay the loan. When a business pledges collateral, it’s essentially granting the lender access to a specific asset that can be seized and sold to recover any outstanding debt if necessary.

Here’s an overview of how collateral may work in a business loan.

Assessing collateral value

When a business applies for a collateral loan, the lender evaluates the asset’s value, liquidity, and marketability. These factors can all contribute to the loan’s size and terms.

Lenders may offer more favorable loan conditions for higher-value assets that are easier to sell (such as real estate), compared to assets that tend to depreciate (such as vehicles). If a business is using inventory or equipment as collateral, the lender will also consider how easily these assets can be sold if necessary.

Signing lien agreement

During the approval process, the business typically signs a lien agreement that grants the lender legal rights to seize the collateral if the loan remains unpaid.

During the loan

The collateral remains in the business’s possession as long as they stay current on loan repayments. If the business misses payments, the lender typically provides notice and an opportunity to resolve the issue before attempting to repossess the collateral.

After the loan is repaid

Once the loan has been repaid, the lender issues a lien release, which relinquishes any claim to the business’s assets under the loan conditions.

Differences between secured and unsecured business loans

The primary difference between a secured and unsecured business loan is that secured loans are backed by collateral while unsecured loans are not. These loans may also differ in loan terms, eligibility requirements, and associated risk.

Secured business loans

Secured business loans are backed by specific assets, like real estate, equipment, or inventory. When a business pledges collateral, it assures the lender that they can seize and sell the asset to recover their losses if the business is unable to pay the loan.

This collateral reduces the lender’s risk, which may result in more favorable loan terms for the borrower, such as lower interest rates, higher borrowing limits, and longer repayment periods. However, using collateral carries a risk –  if the business cannot repay the loan, the lender may seize pledged assets, which could potentially impact operations.

Unsecured business loans

Unsecured business loans don’t require the borrower to pledge any collateral. Instead, the lender assesses their risk based on the business’s creditworthiness, cash flow, and overall financial health. Since unsecured loans aren’t backed by collateral, lenders may impose stricter eligibility requirements, higher interest rates, and shorter repayment terms to manage their risk.

In some cases, lenders may require a personal guarantee from the business owner on an unsecured loan, meaning the business owner is personally responsible for repaying the loan if the business defaults. This allows the lender to pursue the borrower’s personal assets to recover losses if the business defaults on the loan.

Benefits of using a secured loan for business growth

Using a secured loan for business growth can offer potential benefits, such as:

• Higher funding amounts: Collateral business loans may allow for larger borrowing amounts, which businesses can use to secure new locations, purchase equipment, or increase production capacity.
• Lower interest rates: Reduced lender risk may result in lower interest rates, which businesses could allocate towards growth initiatives.
• Longer repayment schedules: Secured loans may offer longer repayment terms, which could help businesses manage cash flow and reinvest into operations.
• Easier access to financing: By reducing lender risk, collateral may make it easier for some businesses with limited credit history to secure financing.

What types of assets can be used as collateral?

Assets that can be used to secure a business loan include real estate, equipment, inventory, investments, and invoices.

Real estate

Real estate, such as commercial properties, buildings, or land owned by the business, is one of the most widely-accepted types of collateral. Lenders generally view these assets favorably as they’re typically stable, have a high loan-to-value ratio, and appreciate over time. Depending on the lender’s assessment, using real estate as collateral may result in more favorable loan terms, such as higher loan amounts and lower interest rates.

Business equipment

Business equipment, like vehicles or machinery, is another valuable asset that can be used as collateral. Unlike real estate, which tends to appreciate with time, equipment can depreciate. For that reason, the equipment’s current market value, age, and condition may factor into the loan terms.

Generally, older or more heavily-used equipment may have lower market value, which could influence loan terms. Ease of sale also plays a role. If equipment is specific to a niche industry, it may not be easy to sell and therefore considered less valuable as collateral.

Inventory

Companies can use unsold inventory as collateral for a loan, often secured through commodity trade finance companies. As with equipment, the inventory’s market value and ease of resale can play a role when assessing the value of inventory as collateral.

Using inventory as collateral can pose risks. If a business doesn’t meet loan obligations, the lender may claim the inventory, potentially affecting the business’s ability to generate revenue.

Investments

Securities like stocks, bonds, or other investments, such as fixed income instruments, can also serve as collateral for a secured business loan. These assets generally appeal to lenders because they are highly liquid and can easily be converted to cash if needed.

Invoices

Businesses that deal with consistent outstanding invoices and delayed payments can potentially pledge unpaid invoices as collateral. This can provide a way to access funds without waiting for invoices to be paid, which may help a business address cash flow issues.

Blanket lien

A blanket lien means the lender can claim all or most of a business’s assets as collateral. If the business defaults on the loan, the lender has the right to seize any of the business’s assets, including inventory, equipment, invoices, and sometimes even real estate.

A business might consider a blanket lien if they’re seeking a substantial loan but don’t have a high-value asset to pledge as collateral. However, this comes with additional risk as the lender can seize nearly all the company’s assets in the event of a default.

How to qualify for a collateral business loan

To evaluate eligibility for a collateral business loan, lenders will typically look at:

• Collateral value: Lenders often prioritize assets with stable and marketable value, such as real estate or high-quality equipment.
• Creditworthiness: Lenders typically evaluate the borrower’s credit history and financial standing as part of the eligibility assessment for a loan.
• Business stability: Lenders may also examine the business’s financial health and stability, considering factors such as cash flow, profit margins, or whether it employs tools such as FX hedging services to manage currency risks.

Comparing collateral business loans and unsecured business loans

The table below compares the key differences between secured and unsecured business loans.

Why do unsecured business loans exist?

Unsecured business loans serve many purposes, including:

• Covering short-term expenses: Unsecured loans can help cover short-term expenses by providing fast access to capital without the burden of long-term debt.
• Providing capital for fast-growing businesses: Unsecured loans often have shorter approval processes, which can allow businesses to respond to growth opportunities more quickly.
• Accessing funds with limited collateral: Unsecured business loans offer a way for companies to secure financing, even if they don’t have high-value assets.
• Avoiding risk: Some businesses may prefer not to pledge assets as collateral. Unsecured business loans offer a way to access capital without using assets as security.

Risks and considerations in collateral business loans

Below are some risks and considerations to be aware of when considering a collateral business loan:

• Asset seizure: If a business does not meet repayment terms, the lender may have the legal right to claim the collateral assets. This could potentially disrupt operations and impact revenue generation.
• Asset depreciation: Assets like equipment or vehicles used as collateral may depreciate in value over time. If this occurs, the lender might require additional collateral to maintain the loan agreement.
• Market volatility: Assets influenced by market conditions, such as real estate or investments, may fluctuate in value. In an economic downturn, for example, the value of the secured asset could fall below the loan amount, potentially leading to additional collateral requirements or refinancing.
• Opportunity cost: Using assets for collateral may limit their availability for other business needs or opportunities.
• Legal and administrative costs: Collateral business loans may involve additional costs, such as legal fees or appraisals, which could impact the overall cost and value of the loan.