Every business faces the need for extra funding now and then to aid in expansion or for support with daily cash flow needs. For new business owners, they may require financial help more often than established companies due to the challenges that face startups. In fact, the number of startups that make it to the fifth year of operation is approximately fifty-six percent.
Lenders will assess your creditworthiness before offering credit by looking at the company’s history, financial records, and business credit. They want to be sure that they can still recover their money even after you default and for this, they require collateral.
Collateral is defined as an asset that is pledged to a lender from the borrower as security to a loan. In case of default, on the loan payment, the lender can recover the amount owed by liquidating the asset.
Here are the different types of collaterals that you can use to obtain a business loan.
According to Thomson Reuters practical law, what counts as real estate in Pakistan is land, benefits arising out of the land, and anything fixed to the land or permanently attached to anything on the land, this includes houses.
Most lenders typically prefer real estate as collateral since it is of high value and does not depreciate over time. According to the IMF, the global housing markets have been increasing steadily since 2012. The high value of property means you can get as much credit as you need as long as it does not exceed its value.
Always consider the risk involved before using the family home or land as collateral. Defaulting on the loan results in loss of the property and this can reduce your net worth. You also do not want a situation where you are left homeless after the lender confiscates the property.
In case your business is product-based, your inventory could work as collateral. The lender will get an independent auditor to value your stock and check if it covers the loan you are getting while putting depreciation into consideration.
Inventory is mainly used as collateral when seeking finances to stock the business in what is called inventory financing. The stock you are about to buy is taken as collateral, and in case you fall into default, the lender takes it back.
Losing your stock as a result of default can cause a problematic situation. Your source of income is gone, and in case you have more debt, there is a high likelihood of defaulting on these lenders too. It adversely affects your credit score meaning getting additional funding will be close to impossible.
Lack of cash flow as a result of late payments by customers is a common problem among small businesses. In fact, a study by Fundbox indicated that 64% of small businesses face this challenge.
When running low on cash for daily operations as a result of unpaid debt, your business operations do not have to freeze. You can use the invoices as collateral to acquire funds in what is known as invoice financing.
The loan advanced will be less than the total payments expected since the lender has to charge fees and interest. Once you collect payments on the invoices, it is your obligation to channel the money back to the lender.
The use of invoices as collateral is convenient for both you and the lender. They are easy to convert to cash. The major risk of using invoices as collateral is the customer’s credit risk. The customer could face insolvency resulting in bad debts.
For small business loans, you could use your personal or business equipment to take a loan. It depends, however, on a few factors such as its value to the lender.
The purpose of collateral is for the lender to have something they can sell in case of default. In relation to this, large machinery may be of little value to the lender despite their high price since it may take too long for the lender to find a buyer.
You could also use the equipment you intend to buy with the loan, as collateral, and then make loan payments with the income the equipment generates. In case of default, the equipment automatically transfers to the lender.
You can use your savings account as collateral by applying for a loan in the bank the account is in. It is known as cash secured loan. The Realistic Loans lender may allow you to borrow an amount equal to your savings or base it on a percentage of the total savings. For instance, you could be allowed only to borrow 90% of your total savings.
Most lenders prefer cash as collateral due to the ease in recovery in case you default. They simply liquidate your savings. It is fast and easy and eliminates the time-consuming task of looking for a buyer of a physical asset.
As much as it is favorite collateral for most lenders, you have to be careful with using your savings as collateral. You can lose all your money if things get bad.
Lien is a legal claim on an individual’s property until a debt is paid in full. A blanket lien can be attached to a business loan. It gives power to the lender to sue and seize your assets or any form of collateral you own until full settlement of the debt is achieved.
Blanket liens offer a lot of security to the lender but is a risky form of collateral for you. You could lose valuable items you were not willing to give up or even lose your entire assets.
With a blanket lien, it’s hard to gain access to additional funds from other lenders since every lender desires to be in the first lien position such that they are the first to be paid off in case you default.
Choosing the best kind of collateral for your business requires careful consideration and assessment while thinking of the short term and long-time consequences of confiscation of the asset.
Here are a few tips to guide you when using collaterals to acquire business funding.
- Keep a record of the things you can use as collateral without the fear of lose. It keeps you from making emotional decisions during emergencies such as committing items that you did not intend to. Always commit an asset that puts no danger to your business and cannot affect your personal life in case of default, and the lender has to liquidate it.
- Keep an updated record of the value of your assets. During valuation, hire your valuer as well whom you trust. Compare your valuation report to that of your lender’s.
- Understand the risks associated with using different types of collateral before making any commitment. Discuss your options with a financial advisor before signing any paper.
- Consider alternative forms of lending such as peer-to-peer, and business-to-business where no form of collateral is required.
In conclusion, you are likely to need a business loan for emergencies, to buy assets, to cover business expenses when cash flow isn’t sufficient, or for investing in real estate.
A collateral is a requirement for all secured loans. You can use real estate, stock, unpaid invoices, business equipment, cash savings, or agree to a blanket lien. For any choice you make, there is a risk of loss in case you default. Always ensure that what you use, you can afford to lose.
Keep a current record of the value of your assets. If you are not sure of what you are getting into, for instance in a situation where a lender requests for a blanket lien, consult with an expert first. If traditional loans feel too complicated for you, remember there is always the choice of alternative lending where the collateral is not needed. Explore your options before making any decisions.
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