If you're trying to obtain a loan for your business, you should know that every lender is going to look for something different to help them gauge whether you are qualified. This can include business or personal credit score, time in business, industry, experience, bank statements, etc. There are many different types of business loans, which can be based on several different qualifications; however, the biggest differentiator for business loans is secured versus unsecured loans.
Secured Versus Unsecured Loans
A secured loan, otherwise known as an asset-based loan, uses collateral assets as security. A business asset is any type of resource that is owned and controlled by the business. If for some reason a business defaults on a loan, the lender can take the agreed-upon collateral asset as repayment. This is to minimize risk for the lender and ensure repayment in the case of default.
An unsecured loan is the opposite. The lender looks at different factors like credit-worthiness and time in business to determine whether and how much they are willing to lend. These loans generally come with higher interest rates but no collateral is needed. If the borrower defaults, the lender cannot go after any of the business’ assets as repayment.
Let's look into secured loans in more detail.
Different Types Of Collateral
The most commonly thought of collateral asset is real estate. Lenders favor this asset type mainly because properties retain their value over time. Also, the more value the property has, the more financing a lender can provide. Collateral can be any type of property, like a commercial building or even the business owner's home. However, if the borrower defaults on the loan, they risk losing the property completely, which can be problematic if their family home is on the line.
Another type of collateral is equipment. Many construction or manufacturing businesses have large, expensive machinery and equipment that can be used to help secure a loan. However, equipment does lose its value over time, so this would not be ideal for companies looking to secure a larger loan with a longer term.
Cash in a business savings account can also be used as collateral. This is a very low-risk type of collateral for the lender because if the borrower defaults on the loan, the lender can use this cash to repay the loan. Generally, cash is used when getting a bank loan, since the bank can easily liquidate the account. Although this is low-risk for the lender, it is risky for the borrower because they can lose their savings.
In a product-based business, inventory (stock or products) can serve as a collateral asset. This is called "inventory financing" and is popular among retailers and ecommerce companies attempting to get a loan to purchase the products they plan to sell. If they cannot sell the products, then the inventory serves as security. Not every lender likes to accept inventory as collateral because if the borrower cannot sell the items, then the lender will most likely struggle to do so as well and take a loss.
Invoice financing is a popular type of collateral for businesses that deal with many outstanding accounts. Some businesses have invoices that can take 30 days or more to get paid, requiring them to get loans in order to have cash on hand to operate day to day. These companies can use their outstanding invoices as collateral to secure working capital. Here, the lender agrees to accept outstanding invoices as the collateral for a loan and advance up to 80% of the invoices to the borrower.
Another type of collateral asset is a blanket lien. However, this asset is not a tangible asset like the others. A lien is a legal claim against the assets of a business used as security against a loan or debt. A blanket lien essentially allows the lender to claim a right on as many assets as it takes to repay the loan that was defaulted on. This gives the lenders a lot of protection but leaves a business owner at the risk of losing everything. Also, having a lien can make it hard for a borrower to get a new loan if they need one, because a lender already has a claim on their assets.
Final Thoughts
When choosing to take out a loan, every business borrower must consider multiple factors like how much they are looking to finance, the type of loan they want and, if it’s an asset-based loan, the best asset to use as collateral. Each type has its advantages and disadvantages, so this is best determined on a case-by-case basis.
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