Collateral Loans: A Guide to Asset-Based Lending for Small Businesses

Your company is doing well. Sales are flourishing, and you’re expanding rapidly, 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 that are 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 are familiar with mortgages and auto loans, 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 financing; you can use inventories or leased equipment instead.

Pros and Cons of Collateral Loans

Collateral loans can offer significant financial benefits, but they are also riskier than other sources of financing, such as unsecured loans.

Pros of Collateral Loans

Smaller enterprises experiencing growth but are unable to obtain a typical business loan may be eligible for asset-based lending. 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 poor credit score or credit history as long as the company is growing. Furthermore, because a secured loan is less hazardous for the lender, you may be able to ascertain 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.

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 full worth of an asset. Typically, invoices are funded for 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 are only willing to fund invoices submitted by other businesses, not 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

Invoice Financing

Businesses with 30-day or longer billing cycles frequently experience cash flow problems due to having to wait for 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 Financing

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 worth of your inventory, but it can cover a significant portion of it.

Equipment Financing

Equipment is required for many types of businesses to run, but paying for a large amount of equipment or a costly 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. 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 business is study the loan terms thoroughly to 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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