Why Does a Bank Require Collateral?

What is collateral?

Collateral is property or other assets that a borrower offers a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses.

Collateral is the second source of repayment the Bank looks for to cover the possibility that the first source of repayment your Small Business's cash flow falters.

Collateral assets come in many forms. Most commonly, Collateral is real property (i.e. an owner-occupied building), but it can also be represented by your Small Business's inventory, cash savings or deposits, and machinery & equipment.

To further limit risks, the Bank discounts the value of the Collateral so that they are not extending 100 percent of the Collateral's highest market value.

Loan-to-value (LTV) is the relationship between the amount of money the Bank lends to the value of the Collateral (LTV Ratio = Loan Amount / Value of Collateral). Higher the LTV ratios represent a higher risk for the Bank.

The type of Collateral used to secure the loan will affect the Bank's acceptable LTV ratio.

For example, unimproved real estate will yield a lower LTV than improved, occupied real estate. These ratios can vary and the ratio may also be influenced by lending criteria other than the value of the Collateral. Your Small Business's healthy cash flow may allow for more leeway in the loan-to-value ratio.

  • Real estate: If the real estate is occupied, the Bank may provide up to 75 percent of the appraised value. Special use properties (for example, a car wash) or vacant & unimproved property would have a lower loan-to-value based on its resale potential.
  • Inventory: The key factor is the resale potential of the inventory — how quickly and for how much money could the inventory be sold. For example, the value for ready-to-go retail inventory would be more than a manufacturer's unfinished materials inventory.
  • Accounts receivable: The Bank may lend up to 75 percent on accounts that are less than 30 days old. The older the account, the less value it holds. Typically the Bank does not lend on accounts older than 90 days.
  • Equipment: If the equipment is new, the Bank might agree to lend up to 75 percent of the purchase price; if the equipment is used, then a lesser percentage of the appraised liquidation value may be advanced.
  • Securities: Depending on the Bank's ability to take assignment, marketable stocks and bonds can be used as collateral to obtain up to 75 percent of their market value.

Want to know more?