Understanding Collateral

Bank loans are usually the least expensive way to finance a small business. However, it is not easy to get a bank loan, as banks have strict standards for lending. As a general rule of thumb, banks will require a borrower to put up collateral for a loan. The only exception to this rule is for clients who have a long-term relationship with banks and whose business has proven to be profitable over a multi-year period.

Collateral is important for banks to reduce their risk. If the business is not able to pay back the loan, a bank may decide to take ownership of the collateral that has been pledged to them in the documents you sign when you got the loan. Usually a bank will not take ownership of collateral if you miss an interest payment, or one or two repayment installments, but will if they feel that their loan is at risk.

In general, banks prefer to have collateral that is easily converted into cash, such as deposits, cars, equipment, or real estate. Their advance rates against these assets will be higher than against inventory or receivables, which are much harder to convert into cash.

Banks will make their own assessment on the value of collateral—and often consider the fair market value of an asset to be much different (and often less!) than what a business owner paid for it. Therefore, it might be wise to have an independent appraiser give you an estimate on the value of your assets prior to going to a bank.

Banks determine an advance rate based on the value of the asset you provide. To set the advance rate, the lender considers the value of the collateral over time to ensure that if the borrower defaults on the loan the bank will still recover the value of the loan principal. The best collateral for a bank is a cash deposit or cash savings, and since they are very low-risk, banks will advance between 95 and 100 percent on this form of collateral. The disadvantage for the business owner is that in case of a default, it is very simple for a bank to take the cash. Moreover, you will not be able to use this cash as long as it serves as collateral for a bank.

Investments such as bonds or shares portfolios can also serve as collateral. Usually the advance rate is lower than for cash, as the value of shares and bonds fluctuates. This form of collateral is only used by large banks.

Probably the most commonly used form of collateral is real estate, either a residence or a commercial building. Advance rates vary greatly depending on the quality, location, and marketability of the real estate. Before the recession, banks were eager to advance up to 100 percent of the value of a residence either through a first mortgage and/or a home equity loan. The financial crash of 2008 and 2009 made clear that the value of real estate can decrease quite rapidly, which resulted in large losses for the banks. Today, banks are generally much more conservative and will advance up to 70 to 75 percent of the value through a mortgage. The same advance rates basically apply for commercial real estate, although in this segment, location is even more important and banks will also consider the creditworthiness of tenants.

Cars are another good form of collateral. Credit unions specialize in lending against cars and offer favorable terms. It is not uncommon that, for a borrower with good credit ratings, a credit union will finance up to 100 percent of the value of the car at very competitive rates.

Another very common form of collateral for a small business is inventory and receivables. The advance rates on these assets vary greatly. With respect to receivables, banks will always exclude receivables older than 90 days and receivables to related parties, such as the owner. Average advance rates on eligible receivables will vary between 60 and 70 percent. With respect to inventory, because its value is hard to assess, banks are very conservative and offer advance rates around 50 to 60 percent, and sometimes lower.

Documentation of a collateralized loan should not take long, as banks use standard documentation. What can take time is the appraisal of underlying assets, which you should discuss with your bank if you need money quickly.

There is a relationship between the term of the loan and the underlying collateral required. Short-term loans (less than two years) are usually covered by inventory/receivables and cash, medium-term loans (two to five years) are covered by real estate or cars. Real estate is the best collateral for a long-term loan (more than five years).

Some information on this page is adapted from content that originally appeared on Nav.com, a Venturize supporter.