What does collateral mean?
Collateral refers to assets that a borrower signs over to a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can sell the assets to recover the money loaned. This means that, if you have ceded an asset to a lender as collateral for a loan, you CANNOT sell that asset without the written consent of the lender. Once the loan has been repaid in full, the lender no longer has a claim to the asset and you are free to sell it if you wish.
Because collateral offers some security to the lender in case the borrower fails to pay back the loan, loans that are secured by collateral typically have lower interest rates than unsecured loans. A lender’s claim to a borrower’s collateral is called a lien.
What can be used as collateral?
To answer this question you need to “get into the shoes” of the lender. The only reason they want collateral is that they need to guarantee they will get their money back, even if your business fails and you cannot repay the loan. As a result, lenders only work with items that can be quickly sold and converted into money. The harder it is to sell the item, the less likely it is that you can use it as collateral.
Common types of collateral are:
- Property e.g. your house
- Vehicles e.g. your car
- Insurance policies
Understanding how assets are valued
Often lenders and business owners view the value of assets differently when it comes to collateral. While you may value an asset based on what it cost, its use, current value and the upper end of what it might sell for, lenders take a more cautious, and sometimes pessimistic, view of your asset.
It costs money to sell your asset
As always there is a cost to ending a loan agreement before time, and particularly when the business can no longer pay its loan instalments. Understanding these costs helps you understand why lenders value assets at less than you would expect.
- Administration costs: Someone is going to have to spend time working on recording the problems, identifying which assets can be sold to cover the outstanding costs, work out the interest charges and when the last payment was made and so on.
- Finding a seller: Once the lender has identified which assets are to be sold, they are faced with the headache of finding a buyer. This might be done by auctioning the asset, in which case they will have to pay the auction costs. If they choose to advertise to find a buyer, then this cost will also need to be covered.
- Transfer of ownership: Assuming that a buyer has been found, the seller now needs to prepare the paperwork required to transfer the asset into the name of the person or company buying the asset. Again someone needs to be paid to do this. In the case of a house, there would also be a seller’s commission to consider and conveyancing fees, etc.
Some assets, such as a house, might already have bonds against them. In this case, the asset cannot be used as collateral but, if a fair amount of money has already been paid into the bond, it might be possible to secure a second bond on the house.
Other assets, such as insurance policies, only have value up to the amount that you have paid so far. This will be the surrender value of the policy, less the costs associated with the administration of the policy and the act of closing the policy.
The point is that there are costs attached to selling an asset and the future is always unpredictable. Imagine if you were a lender and had loaned money to a small business. The owner had offered his house as collateral for the loan and you had valued the house at a specific value. Then an economic recession hits, and the business crashes, and house prices fall dramatically. This would be a disaster for you if you had valued the asset at its full value, because you would clearly lose money. To avoid this type of risk, lenders value assets at significantly less than their true value.
Educate the lender about your assets
You know the value of your assets, but the lender might not. This is something you and your business advisor can work on together to educate your lender. It is important to understand that the lender doesn’t always know the industry in which you operate. In light of this, they may place a low collateral value on a specialised industry-related asset, such as a machine or stock, simply because they do not understand its value in your industry. If you can present a good argument and evidence not only of the value of the asset but also of how easily it could be liquidated, it may be possible to convince a lender to place a higher collateral value on an asset.
Examples of how different types of assets are valued:
If your business sells on credit, an option may be to offer your debtors’ book as collateral. Generally, a lender will place a collateral value of between 30% and 75% of the face value, on payments that are owed to you. Usually, this is only for invoices that are less than 90 days old. If you have more business customers than individual customers, the lender values your accounts more. The bigger the businesses and the more business customers you have, the better, as the lender views this as an opportunity to spread the risk. The quality of your customers is also important and will influence how the lender values your debtors’ book.
Keep in mind that lenders are wary of invoices for customers who are difficult to chase, such as businesses based in other countries. These invoices won’t fetch a high value.
Maybe you have a business that can offer stock as collateral. The value that the lender will attach to your stock will range from 10% to a maximum of 50%. This depends on whether the lender thinks the stock would sell easily under a forced-sale condition.
These are the types of questions a lender might ask:
- How quickly would these items sell?
- How quickly will they go out of fashion?
- Does the stock have to be shipped far, or exported?
- Is it a completed product or would they be selling unfinished goods?
- Is it expensive to store?
- Is it insured, and if so, what are the terms of the insurance?
You won’t get more than 75% of the value of equipment and machines in your business. The collateral value can go down to as little as 10% if it is highly specialised and therefore has a limited market willing to buy (or if it is second-hand as these types of goods are considered to be high risk), or even if it is difficult to move or store and/or can easily be stolen.
Land and buildings usually fetch the best collateral values, sometimes as much as 90% of the book value. Bear in mind though, that anything that makes the sale more difficult is likely to bring the value down to less than 50% of its official valuation. A property will be less easy to sell if it is a building that has been specifically designed for specialised needs, if the building is in a less wealthy area, or if it is anticipated that the property market is going to drop. Any existing mortgage on the property will, of course, be deducted from the value.
Cession of a contract’s proceeds
Does your business deal with contracts? If so, a lender will sometimes consider the cession of the proceeds of a contract (or order that you have landed) as collateral for finance. This means that the contract and its associated income is signed over to the lender in return for the financial loan. The proceeds will then be paid into the lender’s account, or into an account jointly held by you and the lender. The lender first takes their payment and then pays the rest over to you.
As collateral, this kind of surety usually only fetches a fraction of its face value, mainly because the lender doesn’t know if you will fulfil your side of the contract or not.
You can raise the value if you have:
- A good track record
- Testimonials and evidence
A lender will only consider the surrender value of your life or endowment insurance policies as collateral, and will then usually attach a value of no more than 90% of the surrender value of that policy, which will be ceded to the lender.
Stock exchange shares are usually valued at less than 50% of their current value. This is to make provision for the fluctuations in value that will happen should the market dip. If you have less risky assets, they may fetch a higher collateral value, but that will depend on how easy they are to liquidate (turn into cash). Retirement annuities cannot be used as collateral unless you have already reached retirement age and you are entitled to access the money.
Very few lenders will accept forms of investment that are not liquid (available in cash) as collateral, for example pieces of art, stamp collections etc.
Cash and savings
Bear in mind that the interest on the loan will be much higher than the interest received on your savings or cash investments, so think carefully about using your savings as collateral.