The 5 C's of Credit - Collateral
We are to part 3 of our 5 part series about the “Five C’s” – important things lenders may consider when you apply for a loan. Part 1 was about your character & experience and Part 2 was about how to ensure incoming and outgoing cash flows give you enough room to make debt payments. Part 3 turns to collateral which may become relevant if you default on the loan.
What is collateral?
Collateral is one or more assets the borrower (you) offer to the bank in the event the loan is not paid. It is typically physical assets associated with the business such as the business’s real estate property, accounts receivable, inventory, or equipment. The type of collateral used may depend upon the type of loan. For example, a car loan would naturally use the car as collateral.
Lenders take a “lien” on the collateral, which means if you don’t pay, they can take that collateral from you and either sell it at auction or sell the note to someone who will pay. This allows the lender to recover the unpaid loan balance. As financial institutions are not in the business to regularly repossess and sell assets, such as real estate, banks may only require enough collateral to cover all or part of the value of the loan balance plus any legal or selling expenses associated with selling the collateral. Collateral should be seen as a final source of repayment.
In certain circumstances, a business’s assets used as collateral may not have enough value to cover the loan balance. This means the lender may ask for your personal assets such as your home, stocks, or other personal property. It is important that the business can generate sufficient cash flows so that the financial institution will never need to claim your house.
The main focus is that you can show how you are going to repay the loan and what tangible assets you have to bring to the table. It is important to know your numbers, including the value of your assets. This means there is more at stake than just the loan amount.
Next month: Capital - what is it and how does it apply to your business.