
Collateral is an asset you use to secure a loan. Putting down collateral can make it easier to qualify for a loan, but it can be risky for borrowers. Let's look at how collateral works and how it could help you secure a small business loan.
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How does collateral work?
When you apply for a loan, your lender may require you to put down an asset to secure that loan. If you default on the loan, your lender will seize the asset to recoup their losses. In other cases, collateral may not be a requirement, but it can help you secure a lower interest rate or make qualifying for a loan easier.
If you're buying a home or a car, the asset you're purchasing with the loan is used as collateral. So, for example, if you default on your mortgage, the lender will repossess the home. You don't normally need collateral to open a credit card or take out a personal loan, but it can be helpful if your credit is poor.
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Types of collateral
The type of collateral you put down is usually determined by the loan type. Some different types of collateral include the following:
- Real estate: A residential home, business property, or land can all be used as collateral for a loan.
- Vehicles: Cars, trucks, motorcycles, and boats can be used to secure a loan, particularly an auto loan.
- Financial assets: In some cases, you may need to use a financial account as collateral, like a savings account, CD, or investment accounts.
- Valuables: If you have valuables like jewelry or artwork, these can be used as collateral, assuming you've had them appraised.
- Business assets: If you're taking out a business loan, you can use business assets like equipment or inventory as collateral.
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Collateral may not be a requirement, but it can help you secure a lower interest rate or make qualifying for a loan easier.
Pros and cons of collateral
Pros
- You may qualify for a larger loan amount. Because collateral reduces risk to the lender, they may be willing to offer you a larger loan amount.
- You could get a lower interest rate. You may also qualify for better rates and loan terms, which can significantly reduce the amount of interest you pay over the term of the loan.
- It can help improve your credit score. If your credit score is not optimal, making on-time payments every month can help you improve it.
Cons
- You could lose your collateral. Financial emergencies happen to everyone, and if you're unable to repay the loan, you'll permanently lose your collateral.
- The application process is longer. Applying for a secured loan tends to take longer since the lender has to verify your assets.
- It can damage your credit. Taking out a secured loan can temporarily lower your credit score, but your payment history will influence whether your score ultimately goes up or down.
How is collateral used to get a business loan?
Taking out a business loan can be challenging, especially if you don't have a business credit score or you've been operating your venture for less than a year. In these cases, securing a business loan with collateral can make it easier to qualify for the loan.
Start by identifying the collateral you want to pledge. Many different items can be used as collateral, but banks may prefer cash or real estate over a depreciating asset like a vehicle. You can also offer a personal guarantee, which is an agreement that the bank can seize your personal assets if you default on the loan.
Once you know what type of collateral you want to pledge, you'll submit a loan application and the lender will assess the value of your collateral. The bank will present you with a loan offer detailing the amount, interest rate, and repayment terms. If you agree to these terms, you'll sign the loan documents and receive the funds.
It's beneficial to shop around and receive quotes from several different lenders. That way, you can find the best loan terms and minimize how much interest you'll have to pay over the life of the loan.
[Read more: How to Apply for a Small Business Loan]
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