If there’s one aspect of the American dream that seems to appeal to just about everyone, it’s the idea of owning and running your own business. Whether you’ve always dreamed of running an Asian-Italian fusion restaurant downtown, or simply can’t wait to open up that quaint little boutique filled with your own fashion designs, it’s only natural to be excited about someday becoming your own boss.
Knowing that you’re ready to open a small to mid-sized business is one thing, but knowing how to secure the funding you need is another. Unless you’re lucky enough to already have the funds in hand, then you are most likely to get the financing you need via a business loan—and the backbone of a successful business loan application is collateral.
Let’s take a closer look at the concept of collateral and discuss how you can leverage yours the right way to fund the business of your dreams.
Why bother with collateral?
Collateral refers to a piece of property (usually physical) that a would-be borrower pledges to a lender in order to help secure a loan.
Proving that you have collateral effectively does two things: it establishes you as a better lending risk to banks and third-party lenders, and it opens the door to better loan options than you might otherwise not have had access to. Typically, items that make excellent collateral include real estate, cars, business inventory, and even cash savings you may have accumulated.
Loans offered against collateral generally constitute a percentage of the collateral item’s estimated market value. For example, if you are pledging a car worth $20,000 in today’s market, a lender would probably offer you around 85 percent of that value ($17, 000). Collateral helps make loans less risky for lenders, as well as showing that you’re serious about repaying borrowed funds.
In a nutshell: Collateral is your key to accessing to lower interest rates and gives you a higher likelihood of approval in the first place.
How to really leverage collateral to your advantage
To speed up the process of being approved for a business loan via collateral, we recommend keeping a detailed record of your assets. There are different ways to go about this, and a quick search online will reveal a wide range of fancy software and services available. In 90 percent of cases, we recommend that you keep it simple: just add asset data into an Excel spreadsheet, hand it to your lender, and they’ll take care of the rest.
In some cases, (think large, complicated loans with multiple contract clauses), tracking an array of assets via Excel may not be the most streamlined way to proceed. These situations generally call for something more than an Excel spreadsheet, such as software programs which track assets automatically according to current market rates (Oracle is a popular choice).
Once you have a record of your assets, you may present it to a prospective lender where they’ll run it through their own set of criteria to determine its true value.
What if you don’t have enough collateral?
Should you give up, or is it still possible to access financing?
The short answer is yes; there are lenders which offer unsecured business loans (that don’t require collateral) but in general, you’ll need to have superb credit ratings to qualify.
Failing this, your options become thin. But, don’t give up—think creatively and you’ll discover that there are indeed plenty of options available to you.
When vetting lenders, shop around in order to find the most reputable providers and the lowest interest rates and then apply online (if online application services are available).
Don’t guestimate; work out the value of your collateral
One of the most common mistakes made by aspiring business founders when it comes to collateral is overestimating its value according to the current market.
Keep in mind that the lender (should you default on your loan) will have to burn resources to take possession of your collateral, locate a buyer for it, and successfully sell it—not exactly an effort-free endeavor! That said, it’s not hard to see why banks are well-known for being conservative when it comes to assessing a given borrower’s collateral.
Don’t play guessing games with yourself: If you’re unsure as to the true worth of your assets, find an appraiser that can give you a fair idea of the value a bank would likely assign to them, as well as provide you with a report to show your lenders. You’ll want to maintain personal records that attest to the running value of these assets over time.
This helps assure banks that you’re paying careful attention where it really counts. You can do this yourself using financial software and resources designed for the purpose, or you can enlist the aid of a professional financial advisor that can bring additional experience and wisdom to the table.
Understand the risks versus the options
Make sure you fully understand what’s at stake when you use collateral to secure a business loan: Default on your loan, and you will lose the assets whether they consist of your home, your car, or your savings. For this reason alone, you’ll want to make sure you only use property that you alone hold the rights to.
If you don’t have enough collateral to get the loan you want, make sure you’ve considered all possible sources, and don’t be afraid to get creative and make suggestions to your lender. As an example to help you think outside the box, here are some not-so-traditional sources of potential collateral that you could use:
- Jewelry that’s been appraised and certified as being worth a certain amount
- If your business already exists and has a variety of purchase orders open, you may also be able to borrow using those as collateral
- Valuable business equipment and machinery
Prepare to pitch your plans
Approach the application process for a business loan in the same way you would a product pitch for a client. Be prepared to go into rich detail. Are you starting a new local business? Prepare to tell your lender exactly what that business will bring to the community and how you intend to make sure it becomes financially successful. Are you looking to fund renovations or second locations? Expect to explain how your plans will make your business even more successful than it already is.
In short, lenders like to see evidence that you’ve really given some thought to what you’ll do to put this money to good use. A comprehensive, well-thought-out business plan and detailed documentation where warranted will go a long way.
Compare your offers
Once your potential lenders finish reviewing your applications, you’ll begin to receive offers on potential business loans from those interested. Avoid the temptation to accept the first offer that comes through the door, as taking the time to compare them all carefully will have a huge impact on the end result.
Pay special attention to the loan-to-value ratio attached to the offers (remember that an average ratio comes out to about 85% of the value of the collateral.) You’ll also want to pay attention to the total length of the repayment period and the interest rate.
If you feel stuck at this stage about how to proceed, don’t forget that you don’t have to make the decision alone! If you’re not sure whether or not a given option represents a fair shake, don’t be afraid to go over things with a financial advisor before you decide. Ultimately, you don’t want to wind up stuck with a loan agreement that really isn’t fair to you or that will be too difficult to pay back, especially where collateral is involved.
Make banks compete for your business
Before you accept a given offer, consider speaking with your financial advisor about the value of your collateral as it relates to the rates you’ve been offered. Then negotiate in favor of terms that reflect the true value what you bring to the table.
Banks and lending agencies are businesses the same as any other. They earn a large portion of their income by lending funds to people just like you. That said, if you’re a desirable lending risk with a solid reason for wanting a business loan in the first place, they will have a vested interest in making sure you do business with them and not the lender down the street instead! Take your time and consider all of your options before you sign on the dotted line.
Header image via Wonderlane, Flickr.