Role of Collateral in Small Business Loans

Small business loans may require collateral in order to get the best rates and terms. When collateral is used, the loan is considered secured against an asset. Unsecured loans do not use collateral, and the lender assumes most of the risk with these loans. When the lender assumes the risk, the cost goes up for the borrower. Collateral is necessary not only to keep loan rates low but also, in some cases, to even be considered for a loan.

Secured Loans Cost Less

The main role of collateral in business loans is to provide the lender with some security that the borrower will not default. Business lenders evaluate the validity of a business loan on similar principles as a personal loan or mortgage lender. Credit history, yearly income and other financial factors will come into play. In some cases, the business model will also come into play. This is usually the case with new borrowers who are looking to open a business, or a branch of a business, based on business financing. The lender may evaluate the validity of the business plan and proposal in order to determine if it is a worthy endeavor. 

Based on all of these factors, the lender will determine how risky the loan is. The higher the risk of the loan, the more expensive the loan will be over time for the borrower. Collateral, such as a home, car, or other business, will make the loan less expensive. This will give the lender some security in case of default. The lender knows they can seize this asset and sell it in order to pay off at least a portion of the loan.

Secured Loans Are Easier to Obtain

Without collateral, the loan may be entirely out of reach for some companies. It is not possible to obtain a loan without a viable application and a strong credit history. You will also need a business plan to approach a business lender. The plan must include financial projections, legal business licenses, and other information. In many cases, this will be enough to secure a loan if the person seeking the loan has a strong enough financial profile.

However, there are times when the lender will ask for more. This is particularly true in very risky business endeavors such as restaurants, stores or online businesses. When a lender will not extend a loan based on the application alone, collateral may be used to further bolster the financial profile of the applicant. 

Secured Loans Place Risk on Borrower

The major drawback for any borrower using collateral is the inherent risk it places on the borrower. For example, a person placing her home as collateral for a business loan can lose her home if she defaults. Many people fear placing collateral for this reason, and this is a legitimate fear. Even with a viable business structure, there are certain elements that can cause a business to fail that are outside of the owner's control.

In order to protect yourself from seizure of collateral, set aside at least 3 to 6 months of payments on the loan. That way, even if the business fails to turn a profit for a period of time, the basic loan obligations can be met. If you are at risk of default, be proactive to negotiate the terms of the loan to prevent seizure of your assets.