Collateral is an asset of value that a borrower pledges as a guarantee that a loan will be repaid.
Collateral is a tangible or intangible asset pledged to secure a loan. If the borrower stops repaying the loan, the lender can seize and sell the collateral to get their funds back.
“The most common example that people can relate to is a residential mortgage, where a bank loans money but takes a mortgage on the home,” says Mark Fruehm, Senior Manager, Underwriting and Credit Risk Management at BDC, who analyzes and approves business loans.
“The home is the collateral. Similarly, for business loans, collateral is anything that has value and can be sold in order to recoup what is owing on a loan.”
What does collateral mean?
Collateral is an asset that has a specific value and which a borrower can offer as security for a loan to ensure the lender gets their money back if the loan isn’t repaid.
It can include tangible items, such as a building or equipment, or intangible assets, such as intellectual property.
The specific collateral pledged for a loan is typically the item being financed. For example, if a company gets a loan to buy a $1 million building, the building would generally be put up as collateral and part of the securities package for the loan.
“Anything that a lender is financing, if it has value, it is most likely part of the securities package and therefore becomes the collateral in most cases,” says Simon Rivest, a Senior Manager, Underwriting and Credit Risk Management at BDC. “If you're financing a piece of equipment, the equipment will be used as collateral, and if you’re financing real estate, the real estate will become the collateral.”
Collateral isn’t the same as security
The term collateral is sometimes used interchangeably with security, but they are not the same. Collateral is a pledged asset of value, while security is a broader term referring to all the elements the lender uses to safeguard the loan. These include the collateral as well as legal protections and requirements.
Examples of securities
Personal guarantees—A personal guarantee is a commitment by a business owner or shareholder to repay the loan personally if the company fails to do so. Some lenders may require the personal guarantee to include specific assets, such as a home or personal investments. These assets are then considered collateral for the loan.
Other lenders (including BDC) use personal guarantees as security for loans. They do not as a rule list any specific assets in the guarantee. “Such a personal guarantee is a moral commitment to repay the loan,” Rivest says.
Corporate guarantees—A corporate guarantee is a pledge by an affiliated business to repay a loan if the borrower can’t do so. The guarantee could include a specific asset that is pledged as collateral.
Lenders often require personal and corporate guarantees as part of the broader securities package for a loan, especially if the loan amount is greater than the value of the collateral. For example, a lender may agree to loan a company $1 million to buy a building, but the building may be worth only $750,000. In this case, the lender would likely require a personal or corporate guarantee to cover the difference of $250,000.
“If there’s a shortfall and we can’t fully cover the loan amount based on the collateral, then we would look at a guarantee to cover the difference,” Fruehm says.
Covenants—A securities package can also include covenants, which are terms and conditions the borrower must follow. These may involve maintaining certain financial ratios or committing to not take on more debt.
What types of loans require collateral?
Most term, demand and operating loans require collateral. The collateral for term and demand loans is usually the asset being financed. For an operating loan (also known as a line of credit), which is used to finance day-to-day expenses, the company’s accounts receivable and inventory typically represent the collateral.
The type of loan not usually requiring collateral is a working capital loan. These loans are used to finance a business activity, such as hiring a salesperson, creating a website or developing a strategic plan, and not for buying a tangible asset.
“Working capital loans are usually used to buy things you can’t really collateralize,” Fruehm says. “In these cases, the lending decisions are based more on the cash flow of the company and the finances of the shareholders or owners.”
Working capital loans don’t typically require collateral but, as part of the security for the loan, the borrower is usually required to provide a personal and/or corporate guarantee.
What is the difference between a secured and unsecured loan?
A secured loan involves collateral pledged as security for the loan. An unsecured loan doesn’t involve the pledge of any collateral. One example would be a working capital loan.
That said, an unsecured loan still usually requires security in the form of a personal and/or corporate guarantee.
What can you use as collateral?
Collateral for a loan is usually the asset being bought with the loan. For example, the collateral for a vehicle loan would typically be the vehicle itself.
Collateral can be tangible or intangible assets. Examples of the former may include:
- equipment and machinery
- inventory (usually raw material and finished goods)
- computer hardware
- accounts receivable
Examples of intangible assets used as collateral:
- computer software
- intellectual property, such as patents, copyrights, trademarks and trade secrets
- contracts, licenses, franchise agreements and leases
- securities and bonds
What can’t be used as collateral?
Any asset with value can in theory be used as collateral, but some lenders’ rules may differ for what they accept. For example, for personal guarantees, some lenders require a specific asset to be pledged as collateral, while others don’t.
As well, some lenders accept financial assets to be used as collateral, while others don’t. (BDC does not accept financial assets as collateral.)
What happens to your collateral if you can’t pay back a loan?
If a business stops making payments required by the loan agreement, the lender can start proceedings to take ownership of whatever was pledged as collateral and then sell it to generate cash to cover the loan.
“The lender is enforcing what you’ve agreed to, and taking the collateral,” Fruehm says. “They will try to generate cash out of those items, with the aim being to pay as much of the loan back as possible.”
If the proceeds don’t cover the outstanding loan balance, the lender then typically looks to the personal or corporate guarantee to cover the difference.
Missed payments are investigated
When a borrower misses several loan payments, the lender may assign the account to a special department that investigates the situation further and tries to work something out with the borrower to resume payments.
“Is it a temporary cash crunch?” Rivest asks. “Maybe there was a fire at their biggest client’s plant. Sometimes they just need a break from the repayment, and we can allow a postponement or do a quick loan to help with a temporary situation. Or sometimes you investigate and end up seeing a business coming to an end.”
In the latter case, an insolvency trustee is typically hired to coordinate an orderly and fair selling off of the company’s assets, maximizing value for lenders, employees and others to whom the business has obligations.
Seizing assets is a last resort
If a company ends up going into receivership or bankruptcy, the various creditors are paid out depending on their registered position or hierarchy. Secured lenders (those with a loan backed by collateral) are generally at the top of the hierarchy above unsecured lenders; but the hierarchy can vary by jurisdiction and be based on the terms of debt and other agreements made between the lenders.
“Determining the order of events and who has access first and to which assets becomes a legal matter,” Rivest says.
“In these situations, it’s crucial for the main lenders to collaborate and maximize the value, as a quick withdrawal of assets by one lender can impact the overall value for everyone. Various scenarios can arise, but seizing and selling assets is generally considered a last resort after efforts have been made for the business to maintain operations.”
To calculate the costs of a business loan and a monthly amortization schedule, use BDC’s free Business loan calculator.