When it comes to how much collateral is necessary for a loan, the answer varies substantially depending on the details of the loan and the financial situation of the business seeking it. In some cases, the collateral needs to be worth an amount equal to that of the loan, other times the collateral is required to be of a higher value than the loan, and then there are times when collateral isn’t even required.
To understand why the collateral requirements vary so much, it’s helpful to take a step back and look at what collateral is. Collateral is any asset you can offer to a lender to secure the money you’re borrowing. Basically, you’re telling the lender that if you’re unable to pay back what you owe, they can take possession of your asset.
Because collateral is how lenders get paid in the event of a default, they obviously prefer it to be something they can sell easily. This preference means that your collection of Cheetos that resemble US presidents, while priceless to you, probably won’t be accepted by a lender. Examples of legitimate collateral include:
Any loan that requires collateral is called a secured loan because you’re guaranteeing the lender will get paid. When you offer protection to the lender in the form of collateral, they’ll return the favor by giving you more favorable interest rates and repayment terms. And you’ll probably be allowed to borrow larger amounts of money.
With a secured loan, the value of your collateral will usually be equal to the amount of the money you’re borrowing. The math is simple–if you can’t repay your $37,000 loan, the lender is going to want something from you worth $37,000.
In some cases, however, lenders want your collateral to be worth more than the loan amount because t takes effort to turn something around and sell it. If you were to use your cabin as collateral, then defaulted on the loan, the lender would need to hire a real estate agent and would only get repaid once the cabin finally sold.
Some lenders offer unsecured financing that doesn’t require collateral. Because these loans expose the lender to more risk, they’re much harder to come by. If your business has a strong track record and makes $100,000 or more a year, you might be a candidate.
Unsecured loans are usually much smaller than secured loans, with higher interest rates and less user-friendly repayment terms. And they don’t completely insulate you in the case of a default. Many lenders will still require a personal guarantee when you borrow money, essentially making it so you are personally responsible if your business can’t repay the money.
While the exact requirements for collateral may vary, the basic principles remain the same. You are offering up something of value as a guarantee on the money you’re borrowing. And as long as you make your payments, your possessions will most definitely remain your possessions.