4 popular FAQs on collateral and small business loans

To raise a small business loan from a financial institution, a business owner requires two things, a good credit score and a collateral. A collateral is important for qualifying for a small business loan. This is an asset that is pledged to the lender for the time the loan is not repaid. It minimizes the risk for the lender since the asset can be sold if the borrower cannot pay back the loan amount.

If you are thinking of applying for a small business loan, here are 4 popular FAQs that will give you a better understanding of collaterals and small business loans.

Collateral is referred to an asset that a lender accepts as a security for granting a loan. When you apply for a small business loan, most financial institutions will scrutinize your business and personal financial situation to decide whether you are eligible for a business loan. Once this assessment is done, and depending on the size of loan you are asking for, they will ask you to furnish a collateral. In the event of a loan default, the lender forfeits the asset to cover for the losses.

For a borrower, it’s important to come up with a collateral since it will help you get a higher amount of loan. A collateral will also help you fetch lower interest rates when compared to an unsecured loan, simply because the financial risks for the lender becomes lesser. Also, you can choose from a broad range of small business loans that have more favourable terms.

Lenders accept those assets as collaterals that can be converted into cash or can be liquidated quickly. Following are the types of small business loan collateral, lenders generally accept:

Tangible collateral security

- Real estate: Lenders prefer taking both commercial and personal properties as collateral, as the value of the asset often stays stable and increases over time.

- Equipment: While purchasing equipment on a loan, lenders accept the equipment you are buying as collateral. Some lenders also accept equipment as collateral on unrelated loans.

- Inventory: Also known as inventory funding, you can put all your business inventory as collateral to secure the loan. Before accepting it as collateral, the lender appraises the value of the inventory through an auditor.

Intangible assets that can be used as collateral for business loan are:

The borrower can also put his personal assets including your home, car, investments etc. to secure a loan.

Assets, which lose value over time and are difficult to liquidate, cannot be put up as collateral.

To know the value of your asset, a lender conducts a collateral assessment and appraisal review process to determine its fair market value. And, the lender always values the collateral around "fire sale" value rather than market value. This is done to ensure that the lender can recover the loan amount from the pledged asset at the earliest, in case of default.

A lender uses the loan-to-value (LTV) ratio to determine the loan amount to be offered against the proposed collateral. The LTV ratio of an asset depends on the type of collateral and lender. How much collateral you need will depend on the LTV ratio offered on each small business loan collateral. Here is a how it works.

Real estate: A lender offers a loan of up to 75-80% of the value of the commercial or residential real estate property. 

Equipment financing: As the value of equipment depreciates over its life-time, a lender generally offers an LTV ratio of 50-56% for equipment.

Inventory funding: Lenders generally offer LTV of up to 50% for inventory funding.

Account receivable: Typically, a lender offers an LTV ratio of up to 80-90% on invoice financing. Here, the LTV ratio depends on the creditworthiness of your customers.

1. What is a collateral? Why do you need it to get a small business loan?
2. Which types of collateral do lenders accept?
   • Intellectual Property Rights
   • Patents
   • Account Receivable
   • Blanket Lien, and
   • Investment certificates
3. How do I know the value of my collateral?
4. How much collateral do I require?

Remember that collateral alone cannot guarantee a small business loan. Your loan could still get rejected if you are already carrying large debts from other lenders or if you do not have a consistent cash flow or if your business is very new.