Why Do You Usually Need Collateral for a Business Loan?

The idea of collateral is scary for many business owners. That said, it’s often a normal part of lending. What does this process involve, why is it necessary and how can you get around it? This guide can help you make a decision that fits your business’s circumstances and needs.

What Is Collateral?

When it comes to commercial loans, collateral is a business asset offered as a repayment guarantee. It’s a way of showing that you have the ability and the commitment to pay back a loan.

Many assets can work as collateral, but a few are most common: real estate, equipment and inventory. Sometimes, unpaid invoices, vehicles or even jewelry can provide the backing required.

When you provide an asset as security for a loan, it means that the item is covering a part of the financing cost. If you default on the loan — in other words, you can’t repay it — the lender can take your business asset instead.

Why Do Lenders Require Collateral?

This idea of loan security can seem like something straight out of a 1920s Hollywood thriller, but it’s not really that exciting or shady. The majority of loans have some variation of collateral, including small business loans supported by the Small Business Administration, conventional bank mortgages and popular types of alternative financing.

The reason you need a loan guarantee is all about risk versus reward. As a business owner, you know how important it is to plan carefully to make sure your investments deliver a good return. Well, lenders are running a business, too. Before agreeing to lend a lot of capital, they need to calculate the risks and look for ways to make investments as safe as possible.

There are a few ways to reduce risk. Collateral is the main way, but it’s not the only one. Another option is to look at a borrower’s credit rating. Chances are that businesses with great credit are likely to repay the loan in full.

How Does Collateral Work For or Against You?

On the plus side, when you provide collateral, you can get approved more easily for loans. The interest rates, loan terms and total capital offered are usually better, too. Thanks to these assets, you may qualify for loans you wouldn’t get otherwise, including SBA loans, equipment loans or real estate loans.

Of course, you also need to make sure you can make payments. That way, you limit the risk of losing your business asset.