Synopsis: Collateral in a business loan reduces risk for lenders and interest rates. Businesses can pledge various types of collateral. In this regard, understanding collateral types, eligibility and LTV (Loan-to-Value) ratios-a metric to compare the borrowed money against the value of an asset purchased with the loan, helps businesses secure big loans at lower interest rates with ease.

What Is Business Collateral?

Collateral in a business loan is an essential asset that a company puts as security for the loan. Lenders consider it as a guarantee that if the business defaults, they can seize and sell the collateral to recoup their money. There are two significant benefits of using collateral. Collateral decreases the lender’s risk. That’s why lenders are more likely to offer you a lower interest rate on the loan. As lenders get collateral as security, they might be more comfortable approving you for a larger loan amount.

How does it work with business loans?

When you apply for a business loan, the lender closely analyzes various aspects of your business to determine eligibility. They will analyze your cash flow, credit history, business financials, and other aspects. Depending on their analysis, they might offer you a secured or unsecured loan.

If you decide to secure your loan with the collateral, the lender determines the nature of your specific assets that can be considered as collateral. A few examples of collateral are:

• Personal property
• Residential property
• Office equipment
• Production machineries

During the closing documentation before loan approval, you have to sign a lien agreement with the lender. This agreement will grant the lender the right to seize your pledged collateral if you fail to meet the obligations as outlined in the loan agreement.

If you’re a small business owner with limited credit history, lenders might require additional security measures beyond traditional collateral. The lender might follow a common practice in such scenarios, requesting a personal guarantee on your behalf, who will be liable for payment in case your business defaults. 

What Types of Business Financing Require Collateral?

Let’s take a look into the different types of collateral that lenders typically consider for business loans:

Real estate

Real-estate is a highly sought-after form of collateral due to its stability in value. Appraised real-estates, such as land or buildings owned by the business owner, come with a high loan-to-value ratio (a metric to compare the borrowed money against the value of an asset purchased with the loan). That’s why lenders consider personal assets as good collateral and can offer high loan amounts at lower interest.

Vehicles

Lenders consider vehicles as another valuable collateral. In this regard, businesses can leverage work trucks, delivery vans, or even personal vehicles as collateral. If you’re taking a business loan to purchase vehicles, then those assets naturally become the collateral. In the case of old vehicles, lenders might determine the value of collateral depending on the market value, age, and condition of the vehicle.

Equipment

Tangible business assets like machinery, computers, and specialized equipment can also be used as collateral. Similar to vehicles, the lenders will analyze the current market value, age, and overall condition of the equipment to decide its eligibility for the collateral. As equipment is subjected to depreciation over time, lenders will also take this into consideration to decide its worth as collateral.

Inventory

During off-peak seasons, businesses tend to hold a significant amount of inventory. It could be raw materials and finished goods or merchandise. This inventory can be used as collateral for unsecured loans. It is also known as inventory financing. Lenders mainly consider the market value of the inventory and the ease of their liquidation to see how fast they can leverage them to recoup in case of defaults.

Accounts Receivable

Typically, businesses have some outstanding invoices owed to them by their customers. Lenders may consider the value of those accounts receivable as a form of collateral. In case the business defaults, the lender can directly collect payments from customers to recover the losses. However, it is worth remembering that the creditworthiness of customers can influence the value assigned to accounts receivables as collateral.

Savings

Readily available cash in your business account is the highest form of liquidation for lenders. Thus, they can be considered a straightforward form of collateral for lenders. When you have a healthy cash reserve, it demonstrates your financial stability and lowers the risk of default from the lender’s perspective. This readily available funds enables the lender to recoup their investment quickly in case of default.

Personal Guarantee

In some situations, lenders might require a personal guarantee from a business owner or another individual with strong financial standing. The guarantor takes the liability for the loan repayment if the business defaults. That said, the personal assets of the guarantor could then be at risk of seizure to cover the outstanding loan amount.

Eligibility Criteria and Documents Required

Having collateral puts businesses in a favorable state for asking high loan amounts at favorable interest rates. However, it’s also imperative to understand how lenders set the eligibility criteria for applying collateral loans and how the underlying documentation process works to maintain fair expectations.

Eligibility Criteria

Business Stability and Track Record:

Lenders typically prefer businesses with a history of stable operations and profitability. When businesses have such a strong track record, it demonstrates their good finance management skills, which increases the likelihood of successful loan repayment.

Creditworthiness:

Lenders closely examine the credit history of the business and its owner(s). A good credit score indicates responsible financial management and reduces the perceived risk for the lender.

Loan Purpose:

More than the loan amount, lenders inquire for the purpose of the loan. Loans for growing business or acquiring income-generating assets are generally viewed more favorably than loans for operational expenses.

Collateral value:

The value of the collateral offered should be enough to cover the loan amount. In this regard, lenders will typically have a minimum loan-to-value (LTV) ratio requirements. They might only lend a certain percentage of the appraised value of the collateral.

Documents required

Proof of Ownership

Documents demonstrating clear ownership of the collateral being pledged are essential. This could include titles for vehicles or real estate, bills of sale for equipment, or receipts for inventory purchases.

Financial Statements

Lenders might ask for recent audited financial statements or income tax returns to offer a comprehensive picture of your business’s financial health.

Business Plan

If you’re a startup or applying for a big loan, lenders would like to look at your well-defined business plan that outlines your future goals and financial projections. It further strengthens your collateral loan application.

Appraisals

Depending on the type of collateral (e.g., real estate, equipment), lenders might require professional appraisals to determine its fair market value.

Bank Statements

Business and personal bank statements can also add significant weightage as they offer insights into your cash flow, spending habits, and overall financial activity.

Collateral Ratios by Financing Type

Collateral ratios or Loan-to-Value (LTV) ratios specifically represent the relationship between the amount of money a lender is willing to lend and the appraised value of the collateral offered by the borrower. 

Understanding LTV Ratios

Let’s consider your business needs a loan of Rs 100,000, and you pledge a building value of Rs 150,000 as collateral. If the lender approves the loan for Rs 100,000, which is two-thirds of the building’s value, the LTV ratio would be as follows.

LTV Requirements and Financial Types

LTV ratio can vary depending on your creditworthiness and your lender’s policies. Here is a general overview of typical LTV requirements for different financial types.

Commercial Real-estate Loans

Real estate is a stable investment and offers long-term value. Lenders offer higher LTV ratios for commercial real-estate loans. It typically ranges from 70% to 80% value.

Equipment Loans

For equipment loans, the LTV ratio is lower and falls between 50% and 75%. The value of equipment depreciates over time and that makes lenders more cautious with the LTV ratio. 

Inventory Financing

There is a high chance for inventory to become obsolete or lose value over time. That’s why inventory financing typically involves lower LTV ratios. The value can range from 20% to 50%.

Accounts Receivable Financing

LTV ratios for accounts receivable financing can vary as per the creditworthiness of your business customers. Generally, they range from 50% to 70% of the outstanding invoice value.      

End Thoughts

Collateral business loans offer a valuable financing tool for businesses looking to grow and achieve their goals. A brief understanding of different collateral types, eligibility criteria, and loan-to-value ratios even further empowers businesses to approach lenders with a well-informed strategy. However, the traditional loan process can take a lot of time and may involve mountains of paperwork. Thankfully, digital lending platforms are evolving to offer faster, more streamlined solutions at competitive rates. Consider exploring these innovative platforms to unlock the benefits of quick loan disbursement without any hassle.

FAQs

1.   What are the five types of collateral?

Five common types of collateral used for business loans are real estate, vehicles, inventory, accounts receivable, and equipment or machinery.

2.   What are the 4 Cs of credit collateral?

The traditional 4 C’s of credit apply not only to borrowers but also collateral evaluation. The 4 C’s of collateral are character (business reputation), capacity (cash flow), capital (financial resources), and conditions (industry-specific factors).