Three Types of Collateral to Consider for Business Loan Approval
In the small business ecosystem, financing remains paramount. Raising different forms of capital is critical at every milestone in the map of your business. SCORE mentor Hal Shelton urges small business owners to allow for up to two months of lead time, especially if they’re seeking bank loans:
“A common axiom is that the best time to obtain funds is when you don’t need them. Sounds counterintuitive, but during these times you aren’t desperate to take the only offer made. You have time to shop for the best source, with the best terms, and you can negotiate from a position of strength.”
If your business has made promising advances toward growth and stability, future attempts to secure financing may be met with fewer reservations from lenders. Assured by your positive standing, a lender might approve an unsecured line of credit, installment or balloon loan that forgoes the need for collateral, defined by the U.S. Small Business Administration (SBA) as “assets pledged by a borrower to secure a loan or other credit, and subject to seizure in the event of default.” But if you’re new to business ownership, it could be a different story.
As an unproven entrepreneur eager to launch a catering service or accounting practice, you’ll need to raise financing and proceed with adequate funds at hand. But given your minimal track record, the loans you could be approved for will likely be secured loans, which requires pledged collateral. Your collateral management, along with your other vital C’s — capital, capacity and character — will play an important role in your lender’s review and affects not only the onset of your business, but later, its growth and sustenance. The domino effect is clear: Without viable collateral, you’re less likely to gain approval for financing, and without financing, you might not be able to address any of the pressing operational needs or ongoing costs of your business. So carefully weigh the types of collateral to leverage during your loan application process. Some are widely acknowledged, others are misconstrued and most have their share of pros and cons.
1. Personal real estate.
Using personal real estate as collateral is common practice for prospective business owners focusing specifically on secured loans. The SBA, a widely acknowledged provider of secured loans, partners with lending institutions to set competitive terms and benefits and offers a high loan-to-value ratio for your real estate, often up to 80% of its appraised value.
But personal real estate comes with risk. Since it’s considered an illiquid, or fixed asset, and its value prone to fluctuations, your real estate may be worth less over time. And if you do fall behind on your loan payments, you risk losing your real estate through repossession or sale. The good news is, housing prices remain on the rise. Now might be an opportune time to leverage your home equity as collateral, especially, as the housing market appears to show strength.
2. Cash from your accounts.
Unlike personal real estate, cash from your business or personal savings account is a liquid asset. Since a lender deems cash as concrete and accessible collateral — it’s also assumed to be held in accounts with said lender — you may be categorized as a lower risk, and as a result, offered more favorable interest rates with flexible repayment terms designed to help you accelerate your credit building and increase your credit score. These are all positives that work in your favor. Nonetheless, a downside remains: If you default on your loan payments, your lender can easily seize the cash funds in your account, and you might lose your savings entirely.
3. Accounts receivables.
If you’re an owner trying to stay afloat during a particularly volatile season and require a short-term boost of funding to quickly stabilize your cash flow, pledging your accounts receivables as collateral may be the most efficient way to secure the financing you need. By leveraging your unpaid invoices as assets, you can access the necessary cash from your lender without the risks associated with pledging personal real estate. However, since your lender will likely vet your total invoices — rejecting overdue accounts and narrowing the sum to a select number — the final percentage of your loan may be between 75–85% of your invoices’ value.
Accounts-receivable factoring, on the other hand, involves the sale of your receivables outright to a third-party company, known as a factor. In return, the factor advances you funding based on the discounted value of receivables purchased. When your receivables are finally settled by your customers, the factor then returns the outstanding balance to you (minus a one-time fee typically assessed for the service). In this way, factoring companies function as your business’s credit manager throughout the process. With accounts-receivable factoring, you benefit with a quick approvals process and no accruing debt to repay. You can also access as much funding as the value of your receivables allow.
But factoring may have its disadvantages. Once they’re alerted to your factoring arrangement, your customers are then required to settle outstanding receivables with your factor, not you. This may raise red flags about the general health of your cash flow. Accounts-receivable factoring also favors B2B (business-to-business) practices, which generate large numbers of unpaid invoices. So, if you’re a small business owner in the retail space who interacts directly with your consumers, factoring may not be a viable option.
The process of selecting and pledging your collateral, which shows your ability to repay, also reflects your strategic foresight to identify and meet financing needs, so that your business can continue to thrive at every point in its journey. Popular Bank COO Manuel Chinea encourages business owners to consider two pertinent questions, in relation to the cycle of borrowing, financing, leveraging and repayment:
“Figuring out how much to borrow [and pledging collateral to secure financing] is a function of two things. One is, what are you using the money for? What is the need? And two, [what] is your ability to repay the amount that you’re borrowing?”
The information mentioned in this article is for informational purposes only, is intended to provide general guidance and does not constitute legal or tax advice. Each person’s situation is unique and may materially differ from the information provided herein. You should seek the advice of a financial professional, tax consultant and/or legal counsel to address your specific needs before any financial or other commitments regarding the issues related to your situation are made. Popular Bank does not make any representations or warranties as to the content contained herein and disclaims any and all liability resulting from any use of or reliance on such content.