Collateral value is a term that comes up often when talking about business loans. It's important to understand what collateral value is and how to calculate it so you can get a better idea of how much loan you qualify for.
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What Is Collateral Value?
Collateral value is a business term that comes up regularly when businesses are trying to qualify for a business loan. But what exactly is it? Simply put, collateral value is the value of a business's assets.
Here are some examples of collateral value:
- Real estate holdings
- Corporate-owned vehicles
- Anything else of value
A business owner may need to put up collateral (i.e., something of value) to secure a business loan. Collateral is anything of value owned by the company or business owner. These items of value are pledged as security on a business loan. This arrangement helps the lender feel better about lending the money because they know if the business doesn’t fulfill its obligations to repay the loan, then the collateral belongs to them. Usually, the collateral is worth more than the value of the loan. The lender has nothing to lose.
Here are some things you should know about collateral value:
- Most lenders will only loan a percentage of the amount of collateral put up by the company. For example, if a business owns a $20,000 car and uses this as collateral for a business loan, the lender is likely to lend 70% to 80% of the car’s value. In this case, the lender may only loan $16,000 in exchange for $20,000 worth of collateral.
- Collateral doesn't have to be real property. In many cases, companies will use intangible assets as collateral. For example, a company's stock shares may be used as collateral to secure a business loan. The more collateral put up by a business owner, the more likely they are to get a business loan.
- Lenders like safe bets. For businesses that are startups, having very few assets (if any), getting a loan may realistically be an impossibility. Lenders want to know that a startup company is on track to be successful. The easiest way to prove success is to show results. Unfortunately for small business startups, the results just aren't there yet.
How to Calculate Collateral Value
There are three primary ways to calculate collateral value. It's important to understand what these three methods are so you can pre-calculate how much something is worth to get an indication as to how much the bank will lend you in exchange for it.
Here are three ways collateral value is calculated:
- Cost approach: The cost approach is determined by how much it costs to replace or reproduce the item being put up as collateral for the business loan. Appraisers take into consideration how much use the item has endured and make a calculated estimate of how much the actual item costs in its current state or condition. Appraisers use this approach to determine the fair market value of the company's assets, minus its liabilities.
- Market approach: When appraisers adopt a market approach, they're basically determining collateral value based on the value of similar items. A good example of when this happens is when an insurance adjuster is deciding how much of a payout to pay to a customer who's been in a wreck. The adjuster will get several quotes of vehicles matching that same type, within that same locale, and take an average of their findings to come up with the value. This is generally the payout offered to the driver of the wrecked vehicle.
- Income approach: When a business decides to invest in an asset that makes them an ongoing revenue stream, they may use this revenue stream as collateral for securing a business loan. When this happens, the lender will consider future earnings that are expected to come from that investment and then discount the value based on the asset’s risk potential.
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How Lenders Calculate Collateral Value for SBA 7(a) Loans
Small Business Administration (SBA) 7(a) loans have certain collateral value calculation requirements. Calculating the value of an SBA 7(a) loan is important to understand since this is the most common business loan offered to small businesses and startups.
Here are some things you should know about SBA 7(a) collateral value appraisal requirements:
- Lenders are sometimes required to ask borrowers for an independent business evaluation, and this will include an asset valuation. This helps determine what the value of the organization is and how well it's operating. The evaluation must be done through a third-party appraiser for a business to be approved for an SBA 7(a) loan.
- Collateral value appraising is often required by the SBA whenever a loan is taken to assist a change of ownership. This is especially common when the ownership transfer happens between closely related individuals.
When deciding to apply for a business loan, it's important to understand the value of your personal and business assets.
If you're a small business owner, you may be required to put up some personal collateral to cover the cost of the loan. If this is the case, be careful not to guarantee a loan with anything of value that you might miss later. Life happens, and sometimes businesses are unable to pay their debts. When this happens, their assets are seized and sold off. You don't want to lose anything of value that you can't live without.
Remember, when putting up something as collateral, the lender will only offer you between 70% and 80% of the value of the asset used for collateral. If you need a $100,000 loan and are planning to use your $100,000 home as collateral for that loan, just know that you'll only be offered around 70% to 80%, meaning you'll only qualify for a $70,000 to $80,000 business loan.