Collateral Loans – A Guide to Asset-Based Lending for Small Businesses
Your company is doing well. Sales are flourishing, and you’re expanding at a rapid pace, but you’ll occasionally require additional funds to cover the costs that come with such rapid expansion. Asset-based lending, also known as collateral loans, may be able to help your company acquire the funding it needs if it has outstanding invoices or a stockroom full of merchandise.
What is a Collateral Loan?
Asset-based lending and collateral loans are two types of business financing based on the value of a specific asset. Collateral loans and asset-based financing typically involve a company’s equipment or overdue invoices, but they can also include real estate in some situations. Collateral loans are typically employed by businesses experiencing rapid expansion and require more capital to stay up with it. In addition, many organizations employ asset-based loans to deal with seasonal fluctuations in revenue.
Collateral Loans vs Asset-Based Lending
Collateral loans and asset-based financing are interchangeable terms for most business owners and borrowers. On the other hand, financial institutions differentiate between collateral loans and asset-based lending. Collateral loans are secured loans in which you utilize your lender’s funds to buy and own equipment, real estate, or another valuable asset. Most people know mortgages and auto loans, which are both types of collateral loans. If you don’t pay back your debt, the lender has the power to seize your property (or put your home into foreclosure).
Asset-based lending encompasses not just collateral loans but also a variety of additional financing options such as invoice financing, equipment financing, and invoice factoring. Unlike loans, you don’t have to own an asset to acquire the funding; you can use inventories or leased equipment instead.
Pros and Cons of a Business Line of Credit
Collateral loans can provide significant financial benefits, but they are also riskier than other sources of financing, such as unsecured loans.
Advantages of Collateral Loans Asset-based financing may be available to small businesses experiencing rapid growth but cannot obtain a typical business loan. Because the asset secures these loans, a lender may be more inclined to approve a loan for a business even if a credit check finds a negative credit score or credit history as long as the business is growing. Furthermore, because a secured loan is less hazardous for the lender, you may be able to discover reduced interest rates or fees. You might be eligible for a larger loan. The lender has a tangible asset to confiscate if the borrower fails to repay the loan.
If your firm is just getting started or if you can’t get a loan from a credit union, traditional bank, or online lender, collateral loans can help. Many businesses are sole proprietorships, which implies that the owner’s business and personal finances are inextricably linked. If you default on a collateral loan, you only lose the secured asset; however, your lender may pursue your personal assets or personal savings account if you default on an unsecured loan.
Lenders may be hesitant to extend a line of credit to a new firm or one whose owner has a poor personal credit score. But, if they do, it will almost certainly be for a short-term credit line with higher interest rates and smaller credit limits.
Cons of Collateral Loans
The major disadvantage of collateral loans is losing your assets if you fall behind on your payments. You can bet that if you don’t pay back the loan, someone will come seeking for whatever you provided as collateral (equipment, real estate, etc.)
Another disadvantage is that lenders rarely lend the total worth of an asset. Typically, invoices are funded 70 percent to 85 percent of their total amount. If you’re considering invoice finance, keep in mind that some of your invoices may not be eligible for financing. Many lenders will only finance invoices from other firms, not from individuals.
The amount of funding you can get from an asset-based loan is tied to the quality of your receivables, unlike unsecured loans or credit cards. For example, if you’re looking for invoice financing, lenders will be concerned about your clients’ payment histories. If you’re looking for inventory financing or want to utilize real estate as collateral, the lender may want to come out and assess the assets and see how they’re doing. A cost may be charged for an onsite visit, which you would be responsible for paying.
Types of Collateral Loans and Asset-Based Lending
Businesses with 30-day or longer billing cycles frequently experience cash flow problems due to having to wait for too many consumers to pay their bills. When this happens, invoice finance is one alternative available to businesses. The lender makes a loan for a big percentage of the value of your outstanding invoices using invoice financing.
Although invoice finance and invoice factoring are comparable, they are not the same. Invoice factoring is a process in which your unpaid invoices are sold to a third party, whereas invoice financing is a loan.
Inventory finance allows you to receive a loan based on the worth of your inventory if you have a substantial volume of it on hand regularly. Inventory financing rarely covers the entire appraised value of your inventory, but it can cover a significant portion of it.
Equipment is required for many types of businesses to run, but paying for a large amount of equipment or an expensive piece of equipment can be difficult. An equipment loan might help you receive the equipment you need without paying a significant upfront cost.
Business Lines of Credit
Lines of credit are one sort of collateral lending. A company line of credit, on the other hand, can be used several times while a loan can only be utilized once. Because lines of credit can be used as needed, many business owners choose to have one on hand to deal with any unforeseen bills as they come.
Applying for a Collateral Loan: Things to Consider
Although asset-based loans are limited by the asset’s value and secured by the asset, this does not mean that lenders are unconcerned with your company’s performance. So before you apply for a collateral loan, here’s what you should know.
Determine Your True Loan Amount
The loan-to-value ratio is one factor that lenders assess when making secured loans. This is the percentage of the asset’s total worth that the lender is willing to take on. For example, if you pay $1,000 down on an espresso machine with a market value of $4,000, your lender will cover 75 percent of the upfront cost. The loan-to-value ratio is 75 percent. When you apply for a loan, you think about how much you can pay back—don’t just apply for a loan for the asset’s full value. The lender will almost definitely require a deposit.
Gather Your Documents
Lenders will want to see proof that your firm is doing well, so they may request bank statements, business tax returns, and P&L statements in the past. For example, if you’re looking for inventory finance, the lender will want to see that you’ve put together a solid inventory management system. Lenders will also want to make sure your assets aren’t currently being used as collateral for another loan or that they can’t be seized due to tax or other issues.
Read (and Re-read) Your Loan Agreement
The best thing you can do for your company is studying the loan terms thoroughly to ensure that you understand how collateral loans work before signing anything. Ensure you know how payments work and what the lender will do if you don’t pay back your loan. Confirm that the interest rate and costs are reasonable for your budget and consistent with your understanding of the loan.
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