Your business is going strong. Sales are booming and you’re growing at an excellent rate, but sometimes you need extra money to handle the expenses that come along with that kind of growth. If your business has things like outstanding invoices or a stockroom full of inventory, you may be able to get the funding you need through asset-based lending, or collateral loans.
What is a Collateral Loan?
Collateral loans and asset-based lending are a type of business financing that’s based on the value of a certain asset. Most commonly, collateral loans and asset-based lending involve a business’s equipment or outstanding invoices but in some cases, it can also include real estate. Collateral loans are frequently used by companies going through a period of rapid growth and need extra funding to keep up with that growth. Many businesses also use asset-based loans to handle seasonal spikes in business.
Collateral Loans vs Asset-Based Lending
To most business owners and borrowers, collateral loans and asset-based lending are the same things. However, financial institutions distinguish between collateral loans and asset-based lending. Collateral loans are a type of secured loan, which means you use the funds provided by your lender to purchase and own equipment, real estate, or another valuable asset. Both mortgages and auto loans are forms of collateral loans that most people are familiar with. If you fail to repay your loan, the lender reserves the right to repossess the asset (or put your home into foreclosure).
Asset-based lending includes collateral loans but also includes a wide range of other financing products, such as invoice financing, equipment financing and invoice factoring. Unlike loans, you do not necessarily need to own an asset, but can use inventory or leased equipment to get financing.
Pros and Cons of Collateral Loans
Collateral loans can have some serious advantages to your pocketbook, but can also be riskier than other types of funding, such as unsecured loans.
Pros of Collateral Loans
Asset-based lending can be accessible to smaller businesses going through periods of growth but have a hard time getting a traditional business loan. Since these types of loans are secured by the asset itself, a lender may be more willing to approve a loan for a business if a credit check reveals a bad credit score or credit history, as long as the business shows strong growth. In addition, you may be able to find lower interest rates or fees because a secured loan is less risky for the lender. You may also qualify for a larger loan amount. Again, this is because the lender has a clear asset to seize if the borrower defaults on repayment.
Collateral loans also have some major pros if your business is just starting or if you are unable to qualify for a loan from a credit union, traditional bank or online lender. Many businesses are sole proprietorships, which means that there is no differentiation between the owner’s business finances and personal finances. With a collateral loan, you only lose the secured asset if you fail to make your loan payments, but if you fail to repay an unsecured loan, your lender may pursue your personal assets or personal savings account.
Cons of Collateral Loans
The biggest con of collateral loans is the risk of losing your assets if you hit a rough patch and fail to make your monthly payment. If you don’t repay the loan, you can bet that someone will come looking for whatever you used to collateralize the loan (equipment, real estate, etc.)
Another con is that lenders typically don’t loan the full value of an asset. Invoices are often financed for between 70% and 85% of their total value. If you are considering invoice financing, be aware that a lender might not be interested in financing some of your invoices. Many lenders are only willing to finance invoices issued to other businesses, not individuals.
Unlike unsecured loans or credit cards, the amount of financing you can receive from an asset-based loan is tied to the quality of your receivables. For example, if you’re interested in invoice financing, lenders will be concerned with the payment histories of your customers. If you are considering inventory financing or want to use real estate as collateral, the lender may want to make an onsite visit to evaluate the assets and see what condition they’re in. An onsite visit may involve a fee that you would be responsible for paying.
Types of Collateral Loans and Asset-Based Lending
Businesses with billing cycles that are 30 days or longer often run into cash flow shortages if they are left waiting for too many customers to pay their bills. When this happens, one option available to businesses is invoice financing. With invoice financing, the lender makes a loan for a large percentage of the value of your outstanding invoices.
Although invoice financing is similar to invoice factoring, they are not exactly the same things. Invoice financing is a loan while invoice factoring is a transaction where your outstanding invoices are sold to a third party.
If you consistently have a large amount of inventory on hand, inventory financing allows you to get a loan based on the value of that inventory. Inventory financing typically doesn’t cover the full appraised value of your inventory, but it can cover a sizeable percentage of its value.
All types of businesses need equipment to be able to operate, but if you need a lot of equipment or a particularly expensive piece of equipment, it can be hard to pay for all of it at once. An equipment loan can make it possible for you to get the equipment you need while avoiding a large upfront expense.
Business Lines of Credit
Some types of collateral loans can be lines of credit. While the funds you get from a loan can only be used once, a business line of credit can be borrowed against multiple times. Since lines of credit can be accessed on an as-needed basis, many business owners like having one available to them so they can handle any unexpected expenses as they arise.
Applying for a Collateral Loan: Things to Consider
Although asset-based loans are limited by the value of the asset and are secured by the asset itself, that doesn’t mean lenders won’t be concerned with how your business is doing. Here’s what you need to know before applying for a collateral loan.
Determine Your True Loan Amount
One thing that lenders take into consideration for issuing secured loans is the loan-to-value ratio. This number is the percentage of the total value of the asset that the lender is taking on. For example, if you are buying an espresso machine with a market value of $4,000 and you pay $1,000 down, your lender is taking on 75% of the up-front cost. 75% is the loan-to-value ratio. Be sure that when you apply for a loan, you are considering how much you can pay- don’t just apply for a loan amount for the full value of the asset. The lender will almost certainly want some money down.
Gather Your Documents
Lenders will want to see documentation showing that your business is doing well, so they may ask to see things like past bank statements, business tax returns, and P&L statements. If you are interested in inventory financing, the lender will want to see that you have a strong inventory management system in place. Lenders will also need to make sure your assets aren’t already being used for collateral for a different loan or could potentially be seized because of problems with taxes or other liens.
Read (and Re-read) Your Loan Agreement
The best thing that you can do for your business is fully read the loan terms to ensure you understand how collateral loans work before you sign. Double-check that you understand how payments work and what exactly the lender will do if you fail to repay your loan. Confirm that the interest rate and fees are also consistent with your understanding of the loan and manageable for your budget.
The Ups and Downs of Asset-Based Lending and Invoice Factoring