Collateral in finances: Definition, types & examples

Establishing a solid financial base is essential for the smooth operation and growth of a business. 

A critical aspect of this foundation is understanding business collateral in finance. This practice is common among SMB when raising funds, especially if they don't already have favorable credit for other forms of financing. 

However, the strategy demands a sharp understanding. It helps you make accurate financial decisions.

So, it’s not just about raising funds, but making smart choices that match your business goals.

A report by Fundera shows that 48% of small businesses meet their financing needs, with 20% getting loans and 28% lacking enough capital without a loan.

This article breaks down what is collateral in finance, how it works in different scenarios, and provides practical examples of business collateral. 

With this information, you’ll be better equipped to consider different financial options and make savvy decisions for your business.

What is collateral in finance?

Collateral in finance refers to assets pledged by a borrower to secure a loan. These guarantees, which may be tangible (e.g., real estate, equipment) or intangible (e.g., securities, intellectual property), serve as security for the lender, mitigating their risk exposure.

The main aspects of collateral include:

• Risk mitigation: enables lenders to recover losses in case of default by seizing and liquidating pledged assets. Studies show that banks tend to increase their lending after amendments of collateral laws
• Loan facilitation: allows borrowers to access more favorable terms, such as lower interest rates or higher borrowing limits.
• Alignment of interests: creates a mutually beneficial arrangement, promoting more efficient lending practices.
• Legal framework: provides lenders with the legal right to claim pledged assets upon default.
• Versatility: encompass a wide range of valuable resources, adapting to various lending scenarios.

This mechanism fundamentally underpins many financial transactions, balancing risk and opportunity for both lenders and borrowers.

Different types of collateral-based financing options

Let's have a look at the different types of collateral-based financing options in the infographic below:

Common types of collateral for businesses

When it comes to securing loans, businesses have a diverse array of guarantee options at their disposal. 

Let’s delve into some of the most common ones:

• Real estate: whether it’s an industrial factory or residential property, real estate often provides a solid foundation for expansion loans.
• Equipment: for industries like construction, heavy machinery can be pledged as collateral, paving the way for financing new projects.
• Inventory: retail stores can leverage their inventory as collateral, securing a line of credit to effectively manage cashflow.
• Accounts receivable: the funds owed to your business by customers can also act as collateral. For example, a service provider could utilize outstanding invoices to secure swift working capital.
• Intellectual property: while less common, businesses with valuable patents, trademarks, or copyrights can employ these intangible assets as collateral.
• Cash savings or investments: SMB with significant cash reserves or investment portfolios can use these financial assets as collateral.
• Personal assets: particularly for startups or small businesses, owners may pledge personal assets such as real estate, investments, or savings.
• Vehicles: in auto finance loans, the financed vehicle typically serves as collateral.

These examples illustrate the various forms of business collateral available to companies seeking financing, offering a glimpse into the flexibility and adaptability of loan security.

Types of loans that involve collateral

There’s a myriad of financial situations in which loans with guarantees come into play, as outlined in the Federal Reserve Banks’ guidelines. 

Here is a list with the most common types and their typical resources utilized:

• Secured business loans: these are fortified by business assets such as real estate or equipment. The incorporation of collateral mitigates the lender’s risk, making these credits more accessible.
• Equipment financing: this is a specialized loan for procuring equipment, where the acquired machinery itself acts as collateral.
• Commercial real estate loans: these are utilized for purchasing or refurbishing real estate, with the property itself serving as collateral.
• Inventory financing: in this scenario, the inventory acts as collateral. This can be particularly beneficial for retail or wholesale businesses aiming to manage their cashflow effectively.

These loan types are part of a wider financial panorama. 

However, the acceptance of collateral for a secured loan hinges on several factors:

• Loan amount and term: larger loans and extended terms typically necessitate higher quality collateral.
• Industry and business stability: established businesses with steady revenue may have more flexibility in the type of collateral accepted.
• Credit score: even with collateral, your credit history and overall financial health significantly influence the lender’s decision. It means that a robust credit score can facilitate loan acquisition, even with less extensive guarantee.

Each collateral type carries its own advantages and disadvantages, making it crucial to understand these nuances when seeking financing.

Weighing the pros and cons of collateral-based loans

Let's see the pros and cons of collateral-based loans in the infographic below:

Applying for guarantee-based loans can be a strategic lever for your business.

However, like any financial decision, it comes with a spectrum of benefits and considerations.

Advantages

• Competitive interest rates: the presence of a security asset often translates into more favorable rates with lenders.
• Access to larger loans: collateral can unlock larger loans, infusing more capital into your business.
• Improved approval odds: providing a guarantee can tip the scales in your favor when applying for a loan, even if your credit score isn’t stellar.
• Ease of loan acquisition: if you provide collateral, your credit score isn’t the sole factor lenders consider.
• Credit history enhancement: collateral can bolster your credit score over time, even if it’s currently less than ideal.

Disadvantages

• Risk of asset loss: if you default, the asset used as collateral is at risk, which can have repercussions for your business.
• Valuation challenges: determining the accurate value of collateral can be complex and potentially prolong the lending process.
• Usage restrictions: some forms of collateral may come with usage or sale restrictions during the loan term.
• Potential credit damage: defaulting on a collateralized loan can negatively impact your credit score.
• Overcollateralization: you may need to pledge more collateral than the loan’s worth, which can pose issues if the collateral’s value decreases or if you need it for other purposes.

This balanced perspective helps businesses make informed decisions when considering collateral-based loans.

How does collateral work?

The collateral mechanism in lending serves to reduce the risks for the lender while simultaneously facilitating negotiation terms for the borrower. 

Here’s a simple example to help you understand how this type of loan works.

Manufacturing Co. needs a loan for its expansion and owns a commercial property that can be used as collateral. 

If the owner decides to use it, the typical process follows like this:

• Asset valuation: the lender evaluates the market value of the proposed collateral.
• Loan-to-Value (LTV) ratio determination: the creditor then sets the loan amount, which is typically a percentage of the collateral’s value (for instance, an 80% LTV).
• Legal documentation: both parties enter into a binding agreement that outlines the loan terms and details of the collateral.
• Loan disbursement: once the documentation is complete, the funds are disbursed to the borrower.
• Repayment phase: the borrower complies with the agreed-upon repayment schedule.
• Collateral disposition: upon full repayment, the lender relinquishes their claim on the collateral. But, in case of default, the creditor exercises their right to seize and liquidate the collateral to recover the outstanding debt.

Discover a new way of financing with us

Grasping the role of collateral is an important step towards enlightened lending decisions. But securing a loan that fuels the enduring success of your business transcends mere assurance.

So, how about exploring a new way of financing? Talk to our team today and witness firsthand how we cater to your financial needs, bypassing the complexities of collateral.

With Stenn, you can secure the future expansion and streamlined way.