If you have taken out a business loan before, chances are you’ve encountered the term collateral at least once or twice. But what exactly does collateral mean? Do you understand how it potentially affects your loan applications? Let’s explore the basics to help you understand the concept of collateral and how you can make smart decisions about secured and unsecured loans.
What is Collateral?
Investopedia defines collateral as an asset that a funding provider accepts as security for a loan. If you’re trying to apply for a large loan, providers would generally require you to submit collateral. However, if you fail to meet the loan repayment terms, your funding provider can seize the collateral and resell it to recoup the losses.
Understanding the Concept of Secured and Unsecured Loans
When you apply for secured loans, you pledge your assets to the lender and agree to give them the right to repossess the collateral if the loan is not paid on time. With the submission of collateral, funding providers are given the assurance that whatever happens, whether you fail to pay for the loan on time or totally default on the loan, they have something to compensate for it.
Note that even when the provider is given the right to repossess your assets, this does not get you off the hook. You could still end up owing them in case the money they got from the sale of your asset did not cover the full amount of your loan. In this case, you are still financially liable for the remaining balance in your loan.
The Secured Loan (Collateral Loans)
The plus side to applying for a secured loan is that funding providers typically charge a lower interest rate. This is because collateralised loans are considered low-risk loans. Aside from possibly being qualified for a lower interest loan, providers are also more likely to approve secured loans from borrowers who have a poor credit standing. Suffice it to say, secured loans are ideal for borrowers with fair or poor credit who want to take advantage of lower interest loans. Before committing to these loans, you need to understand the risk: When you give the financing company the title to your assets, you are giving them the right to seize your possessions.
Types of Collateral
Putting up your property as collateral is one of the most common decisions borrowers make. This includes real estate, personal assets, cars, motorcycles, and the likes. Real estate is ideal because it has high value with a low risk of depreciation. Beware though that payment defaults from your end could easily lead to the loss of your property.
Financing providers have the right to take ownership of your property if you fail to hold your end of the loan payment terms you agreed to. After the property is seized, the provider may or may not hold your property—they may also choose to sell the property, usually for considerably less than market value, because the provider is most interested in recovering cash quickly. You still bear all the price risk when the provider chooses to sell your assets.
Anything you use to run your business can be used as collateral like printers, copy machines, and computers. Expect that funding providers will most likely ask for the receipt of the equipment being submitted as collateral to assess its value.
Borrowers have the option to use cash as collateral. They simply need to take out a loan from the same bank where they maintain an active account. By agreeing to use the cash in their active account as collateral, the borrower is allowing the financing company, in this case, the bank, the right to the cash in his active account to recover the full amount of the business loan.
Using your inventory as collateral means you agree to give the financing provider the right to seize your inventory should you default in your loan payments. In such cases, the provider could sell the items listed in the inventory.
Small businesses also have the option to use future payments from their invoices as collateral for a business loan.
Blanket liens collateral
The last type of collateral borrowers can use is a lien. A lien is defined by the Corporate Financial Institute as a legal term which allows financing companies to dispose of the assets of a business that is in default of its loan.
The Unsecured Loan
As you might expect, the terms of an unsecured loan are different from that of a secured loan. The most important of which is that secured loans do not require borrowers to pledge their assets as collateral. Thus, when borrowers default on the business loans, it does not put their assets at risk like secured loans do.
To be qualified for an unsecured loan, borrowers need to build good credit. Otherwise, if their credit history is questionable, their business loan application will likely be rejected. Another key advantage of unsecured loans is their availability through online financing providers and credit unions, not just banks. The requirements are also simpler. However, the loan amount is usually smaller. Unsecured loans also tend to charge higher interest rates since the absence of collateral makes the loan higher risk.
Making Profitable Financial Decisions
Ask yourself if you really need the additional capital for something profitable. If you are really keen on taking out a loan, explore all your options. Research different financing providers and compare the rates and terms they are offering.
Whether you choose a secured or an unsecured loan, the reality is that different loans have different business loan requirements, terms, and policies. Ponder on their merits and drawbacks. Which one works better for your business and your current financial situation? Before you decide, make sure you have it all clear in your head.
Clarity is the first step to making smart and informed business financial decisions. At First Circle, we simplify business financing for local SMEs who are keen on getting additional funding to help them achieve their business goals.
Is your business struggling with capital shortages? We are here to help. Click here to apply for a business loan.