Collateral Loans: Should Your Small Business Get One?
Collateral loans are a common financing option for businesses, especially those seeking large loan amounts. This funding relies on collateral or asset value to cover the unpaid loan amount in case the borrower defaults.
Collateral or assets can make or break loan applications. According to the 2024 Small Business Survey, 83% of banks use collateral to vet applications for small loans (up to $25,000). For large amounts (up to $3 million), that percentage goes up to a whopping 98%.
These numbers emphasize how risk-averse financial institutions are. This is why the higher your collateral value is, the more favorable loan terms you’ll get.
In this article, you’ll learn more about collateral loans, including:
What they are and how they work
Examples of collateral loans
The advantages and risks of getting these types of loans
The differences between secured loans like collateral loans and unsecured business loans
How to decide which loan type to get
What Are Collateral Loans?
Collateral loans, sometimes called secured loans or collateralized borrowing, use a borrower’s valuable assets as a guarantee. Ideally, the assets’ value should at least match the loan amount, if not exceed it.
Commonly used collateral includes:
Savings accounts
Brokerage or investment accounts
Vehicles
Real estate
Equipment
Inventory
Accounts receivable (unpaid invoices)
Collateral loans are term loans, which means there’s an agreed repayment period, interest rate, and annual percentage rate (APR). The APR includes the total cost of borrowing (including the origination fee or the cost of processing the loan). In exchange, the lender advances a lump-sum payment to your business’s bank account.
To repay, borrowers make equal monthly payments or installments. If you miss your payments, most lenders offer a grace period.
You can apply for collateral loans at banks, credit unions, and private/online lenders.
How Does Collateral Work?
When applying for business collateral loans, borrowers pledge their assets through a lien agreement. This document gives the lender the right to seize the assets if the borrower defaults. As a result, lenders are assured that the borrower will repay because their property or even business is on the line.
What happens if the borrower still defaults? The lender will sell the collateral to pay off the loan. If there’s still an unpaid amount left, the lender can take legal action.
Some lenders avoid this situation by requiring a personal guarantee on top of the collateral. Borrowers will then have to pledge personal assets like jewelry and other property.
4 Examples of Collateral Loans
Collateral loans are often categorized by the type of collateral used. Below are some common examples:
Commercial mortgages are used to buy offices, retail stores, and factories. As such, the property itself is the collateral. If you default, the bank can foreclose that property and sell it.
Auto loans are used to buy service vehicles. Similar to a mortgage loan, the asset being purchased is the collateral. If you default, the lender can repossess the vehicles.
Equipment loans use the purchased equipment as the collateral. Businesses often get this loan to upgrade their machines without draining their working capital.
Home equity loans or home equity lines of credit (HELOCs) use the equity that your house has gained over the years to calculate your loan amount. The maximum amount is around 80% of your combined loan-to-value ratio, or the difference between the loan amount and your home’s value.
While these examples have limited use cases, some business collateral loans have more flexibility, which means you can use them for any purpose and you may also need to determine which assets you will offer as collateral.
Advantages of Collateral Loans
While applying for collateral loans can be complicated and lengthy, getting approved can give you the following benefits:
Lenders can give larger loan amounts for high-value collateral.
You can often get lower interest rates since you’re considered a low-risk borrower.
In general, collateral loans have flexible repayment terms. You can use these funds for short-term expenses, but they’re ideal for long-term investments (like real estate purchases).
Collateral loans can help you build (or rebuild) your credit score and credit history.
This loan is also more accessible for businesses with bad credit since they can use their collateral as a guarantee instead of credit history.
Risks of Collateral Loans
While the terms for this type of financing might be competitive, you also need to consider the potential risks of collateral loans:
You can lose your assets if you don’t have a solid repayment plan.
If you pledge your assets, they can’t be sold until you’ve repaid the loan.
If you default, it can negatively impact your credit history, which will make it difficult for you to apply for future loans.
Since the application process can be lengthy (depending on the number of collateral to be appraised), you might miss out on investment opportunities.
Secured Loans vs. Unsecured Loans
Unsecured loans don’t require collateral. Instead, unsecured loans rely on other eligibility requirements, particularly creditworthiness.
Here are the main differences between secured and unsecured loans:
Unsecured loan requirements often include a credit report that demonstrates a strong history and score. Some lenders also evaluate your bank account transactions to see how much money is coming in (cash flow).
Unsecured loans tend to have higher interest rates because of higher risks.
The loan amounts for unsecured loans depend on your creditworthiness, income, and other debt instead of the collateral’s value. This is why unsecured loans tend to have lower amounts.
In general, unsecured loans have shorter repayment periods, which can result in higher monthly payments.
The approval process for unsecured loans can be much faster since it doesn’t need a collateral appraisal.
Which Loan Should You Get?
There are many loan options available, so it’s best to carefully evaluate which one suits your business profile and financial capabilities.
Consider the following:
If you need the money immediately, then collateral loans might not be the best option since their approval process can take weeks and even months.
If you have strong business and personal credit scores but few assets, then unsecured loans might be more accessible for you.
If your business is growing quickly but has not established a credit history, you can consider secured loans to build up your credit score.
If your business has bad credit or high debt but many assets, you can consider secured loans, especially since you might have limited loan options.
If you’re planning to make capital-heavy investments, like building a new office or renovating a retail store, then you can take advantage of the better terms offered by secured loans.
Remember that all loans have risks, so it’s best to understand your financial health to make the right decision. Review your financial performance and business assets to calculate how much collateral you need to hit your target loan amount. Additionally, compare each lender’s fees, penalties, terms, and disclosures to see which loan program is most cost-effective for you.
Get Fast, Flexible Financing Through Backd
Collateral loans can be a great financing option, but there are other flexible funding alternatives available with competitive rates and terms — without the need for collateral.
For example, Backd’s Business Line of Credit offers up to $750,000 in funding for any purpose. In addition, Backd’s Working Capital Advance provides up to $2 million with automatic daily, weekly, or semi-monthly payments.
You can receive a decision in less than 24 hours once you submit your application. Plus, we do a soft credit pull to evaluate your application, so it doesn’t affect your credit score.
Our requirements include:
$100,000 in monthly revenue
625+ credit score
Established business credit
Based in the U.S. with a brick-and-mortar address
One year of operation for the Working Capital Advance and two years for the Business Line of Credit
Apply now for funding that matches your business needs.
