When applying for a business loan, one of the key considerations is whether you’ll need to provide collateral to secure the loan. Collateral acts as a safety net for lenders, giving them the assurance that they can recover their funds if you’re unable to repay the loan. While not all loans require collateral, understanding when and why it’s necessary can help you make more informed decisions during the loan application process.
In this guide, we’ll explain what collateral is, when it’s necessary, and how it affects your business loan application.
Collateral is any asset or property that you pledge as security for a loan. If your business fails to repay the loan as agreed, the lender can seize the collateral to recover their funds. Collateral can take many forms, including real estate, equipment, inventory, accounts receivable, or even personal assets.
There are two main types of collateral:
Secured loans: These require collateral to secure the loan. If you default, the lender can take the collateral.
Unsecured loans: These loans do not require collateral. Lenders rely on your creditworthiness and ability to repay the loan.
If you apply for a secured loan, the lender will typically require collateral. Secured loans offer lower interest rates and better terms because the lender has the security of the collateral. Common types of secured loans that may require collateral include:
Term loans
SBA loans
Equipment loans
Lines of credit
Lenders use collateral to mitigate the risk of lending. Since secured loans are tied to specific assets, they are considered less risky for lenders than unsecured loans, and they often come with better terms for borrowers.
If your business has a low credit score or limited financial history, lenders may be more likely to require collateral as a way to protect themselves from the risk of default. Collateral reduces the lender’s risk, as they can recover their funds by selling the pledged assets if you fail to repay.
Collateral helps offset the increased risk associated with lending to businesses with less-than-perfect credit. By offering collateral, you demonstrate to lenders that you’re committed to repaying the loan and that you have valuable assets to back up your loan request.
For larger loan amounts, especially those exceeding $100,000, lenders are more likely to require collateral to secure the loan. Larger loans represent a higher financial risk, and lenders may need the added security of collateral to feel comfortable approving the loan.
For large loans, lenders need more assurance that they will be able to recover the loan amount if things go wrong. Offering collateral makes it more likely that your loan request will be approved, and it may help you secure better terms.
Some types of loans, particularly equipment loans or commercial real estate loans, require collateral to back the loan. In these cases, the asset being financed (such as equipment or property) often serves as the collateral.
In asset-based loans, the collateral is directly tied to the loan, making the loan more secure for lenders. Since the loan is being used to purchase or lease a specific asset, that asset serves as collateral to protect the lender in case of non-payment.
The type of collateral required can vary depending on the loan, the lender, and the size of the loan. Here are the most common types of collateral:
Real estate, including commercial properties, land, and buildings, is often used as collateral for larger loans. If your business owns property, it can be leveraged to secure financing.
For businesses that require specialized equipment (such as machinery, vehicles, or computers), the equipment itself can serve as collateral. Equipment loans are a common option for businesses looking to purchase or upgrade equipment.
Inventory, including raw materials, finished goods, and supplies, can be used as collateral for a loan. Inventory-backed loans are common in retail, manufacturing, and wholesale businesses.
Some lenders will allow you to use accounts receivable (outstanding customer invoices) as collateral for a loan. This is often the case with invoice financing or accounts receivable financing.
In some cases, especially for small business owners or sole proprietors, personal assets (like your home, savings, or personal property) may be required as collateral. This is more common in small, owner-operated businesses that may not have sufficient business assets.
In certain cases, you may be able to use cash savings or certificates of deposit (CDs) as collateral. This is more common with smaller loans and can provide a low-risk option for lenders.
Lower interest rates: Since the loan is secured by collateral, lenders view it as less risky, which often results in lower interest rates and better terms.
Higher loan amounts: Offering collateral can increase your chances of securing a larger loan, especially if your business’s creditworthiness is not ideal.
Better approval chances: Collateral can make it easier to get approved for a loan if you have limited credit history or a low credit score.
Risk of asset loss: If you default on the loan, you risk losing the asset you pledged as collateral, which could be your business property, equipment, or even personal assets.
Limited flexibility: Some loans with collateral may have strict terms, limiting your ability to sell or refinance the collateral without the lender’s consent.
Personal risk: If you pledge personal assets (e.g., your home or savings), you take on personal financial risk, which could affect your personal financial stability.
If you’re concerned about offering collateral, there are alternative financing options that may not require it. These include:
Unsecured business loans: These loans don’t require collateral but may come with higher interest rates and stricter credit requirements.
SBA microloans: Some SBA loans are unsecured and can be an option for businesses that don’t have substantial assets to pledge.
Lines of credit: Some business lines of credit don’t require collateral, depending on the amount and the business’s creditworthiness.
Revenue-based financing: This type of financing relies on future revenue to repay the loan and does not require collateral.
Collateral is an important consideration when applying for a business loan, but it’s not always necessary. Understanding when collateral is required and the types of assets that can be used as collateral will help you navigate the loan application process with confidence. If you’re not comfortable offering collateral, explore alternative financing options that don’t require it. Regardless of the loan type, ensure that you carefully evaluate your business’s ability to repay the loan and protect your assets in the process.
If collateral is required for your loan, ensure you understand the terms and are comfortable with the assets you’re pledging. By taking the time to carefully consider your options, you can secure the financing your business needs while minimizing risk.