Why Do Lenders Require Collateral?

When you apply for a loan, the bank usually wants to know what you can put up as collateral. Yet not all forms of collateral are as appealing to banks as others. Find out why lenders need collateral and what qualities they look for in it. 

Getting an unsecured business loan is nearly impossible these days unless you are tremendously wealthy, a multi-national organization, or don’t really need the money. The one exception would be a government bailout. Thus, collateral does matter.

However, banks and other lenders don’t really want your collateral. They’re not in the collateral business — they’re in the money business. It’s too costly for them to take ownership of such collateral should your business default on payments. Traditional lenders even have to fund allowances for loan loss accounts when the loan is funded and write down the assets value on their books (not market value) when a loan comes past due — all to reduce their losses against faulty borrowers.

Since this seems so painful for lenders, why do they (lenders, banks, financial institutions, and other business financiers) require collateral?

Sources of Repayment

Most business lenders look for three sources of repayment. The first is always the business’s ability to repay the debt through cash flow. Cash flow in this case means operating profits or the conversion and sale of current assets (usually inventory) — operating cycle cash flow. 

If the business fails to generate enough cash flow, the banks and other lenders want to be certain that they are made whole — not just for the repayment of the principal amount, but for any lost interest, fees, and costs of taking and selling the asset. 

To cover the possibility your cash flow will falter, lenders look at a second source of repayment — which stems from the value of the collateral.

Just for clarity, the third source is usually in the form of personal or business (other businesses) guarantees for repayment.

Appraised Value

Banks look for several criteria in evaluating collateral. First, the appraised value. The appraised value has to, at the least, cover the amount of the loan. Additionally, if lenders have to take your collateral, they will seek to liquidate it as soon as possible. Therefore, they would expect your collateral to cover the amount of the loan plus 20% to 50% depending on the collateral (the amount they would lose should they have to fire-sale the assets).

This protects the lender in several forms. First, should they realize substantial costs in reselling the collateral, they’re covered. Second, should the business (borrower) have a large financial stake in the collateral — say 20% to 50% — it’s less likely the borrower will just walk away from the loan.

Can it be resold?

Banks and other lenders also look at the type of collateral being pledged. If the collateral can easily be sold to many different businesses, it has more value as collateral.

Take, for example, a delivery van. Many businesses and industries use delivery vans. Thus, the bank could reasonably believe that it could quickly resell the van if it had to. Should the collateral be a special mold injection machine that produces one unique product that only you sell, then this asset may not be lendable — either requiring a higher appraised value, more down payment, or denial of the loan.

This really comes into play with real estate. Raw land is very hard to lend against. Improved land is better because it’s more salable, as long as it’s not improved for a single purpose like a car wash facility or mobile home park. Office buildings, warehouses, and manufacturing spaces are the best because multiple businesses and industries can utilize these types of real estate, making them better for resale.

UCC-1 Filings

Additionally, banks and some other lenders, in order to protect themselves from reduced future collateral value and other market risks, will take a blanket UCC-1 filing on all business assets including pledged and non-pledged collateral. A UCC-1 (UCC stands for Uniform Commercial Code) filing gives the lender a legal claim to all of the borrower’s business assets should the borrower default on the loan.

This helps these lenders should the borrower walk away without ever making even one single payment; they would be able to cover their losses by liquidating all of the business’s assets. Keep this in mind when seeking traditional bank debt.

Thus, collateral does matter and is a major requirement of nearly all business lenders — it’s just a fact of business life. If you plan for this in the beginning, you can avoid being surprised later and will stand a better chance of securing the capital your business needs.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.

Copyright 2009 – BusinessMoneyToday.com 

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