What is Loan Collateral?

When you apply for a business loan, most lenders will expect you to pledge some collateral. And when you’re repaying your business loan, situations might come up where you need to change your pledged loan collateral. such as selling old equipment or buying new equipment.

Before you take any actions that involve your pledged collateral, you have to work with your lender to ensure that your loan agreement is properly updated – otherwise, you may end up defaulting on your loan.

Here’s what you need to know about loan collateral, what could change it, and most importantly, how to avoid a default on your small business loan related to your collateral.

What is loan collateral?

Simply put, loan collateral gives your lender protection against worst-case scenarios. For example, if you don’t make your payments as agreed and your loan goes into default, then your lender can claim the pledged loan collateral assets to help cover part or all of the remaining balance on a loan. This type of loan is called “secured debt.”

Since loan collateral reduces some risk for lenders,   they can offer lower interest rates and longer repayment terms for these loans. A good example is the difference between the interest rate for an auto loan and the interest rate for a credit card. Because your lender will use the car you just financed as collateral for an auto loan, they can offer a lower interest rate. Credit cards have a much higher interest rate because they’re considered unsecured debt and don’t have any loan collateral associated with them.

For small business loans, pledged collateral can include your equipment, inventory, commercial real estate purchased with the loan, and even personal collateral, such as your home or car.

Reasons for selling or replacing your pledged collateral

When your business is growing or expanding (or, in some cases, closing), you might be in a situation where you’re making big changes to your pledged collateral. It’s important to be aware of the kinds of actions that may accidentally trigger a default on your loan if you don’t take the necessary steps first.

You may need to make a change to loan collateral if:

1. You need to replace the equipment that was originally used as loan collateral so that you can update or upgrade your production or services.
   
2. You’re changing locations to expand your business and want to sell off the existing furnishings and equipment to purchase new ones for the new location.
   
3. You’ve adjusted your business model and no longer need some equipment or inventory.
   
4. The manufacturer of the equipment that you use made a change that makes your existing equipment no longer serviceable or repairable.

These circumstances (and many more) are common for small businesses. As long as your lender is aware of and approves any potential changes to your pledged loan collateral before they happen, they can update your loan agreement to reflect changes and ensure that your loan is in compliance.

Remember: You can’t sell the assets you pledged as collateral without your lender making adjustments to your loan agreement. Think about car loans as an example. You wouldn’t be able to sell the car you’re financing without notifying the lender for your auto loan. Similarly, your business lender needs to know about potential changes to your pledged loan collateral before you make them.

What to do if you need to sell or replace your loan collateral

If you’re in a position where you need to sell or replace your pledged loan collateral, here are the essential steps you’ll need to follow to ensure that your loan stays in compliance with your financing agreement.

1. Contact your lender. If you have pledged collateral for a loan with an outstanding balance and need to sell the collateral, you must contact your lender before selling or replacing it.
   
   Typically, you’ll work with your lender’s loan-servicing department. They’ll need to know specific details about the existing pledged collateral and what you’re planning to change. This allows your lender to make an informed decision on what will be needed to revise the loan agreement without triggering a default.
   
   Every business and loan have their own unique circumstances, so there aren’t any “blanket” actions to be taken by the servicing department. They’ll need specific information on your business and loan collateral to keep your loan in compliance with the changes. Know that it can take time for your lender to complete the necessary actions to keep you in compliance, so it’s best to get the process started with them as soon as possible.
   
2. Prepare a list of pledged collateral and available assets. Know what you’ve already pledged for your existing business loan (and any other loans that are outstanding), what you have available as new collateral (such as equipment you may have bought without a loan), as well as information about any new assets you plan to purchase.
   
   Some lenders allow an asset to be pledged multiple times, although they aren’t required to do so. There’s a lien order that must be followed and with a servicing action, a lender may place a supplemental lien on collateral where they take the second or third position. Simply put, this means that if your pledged assets have to be liquidated, the first lien is paid first, the second lien is paid second, and so on.
   
3. Show how you plan to finance the new assets. If you’re planning to sell an existing asset and will purchase a new asset to replace it:
   
   
   • If you need new financing to purchase the asset, then typically, your lender ask you to pay off the existing loan balance with proceeds from selling the existing asset. Then the lender will release the collateral filing.
     
   • If you don’t need new financing, your lender will replace the existing collateral filing of the item being sold with a collateral filing for the new item being purchased.

Your lender will determine how the sale proceeds are used

In cases where the sale proceeds are more than the remaining balance on your loan (and any other liens on the property you’re selling), you’ll get some or all of the balance. And in cases where the collateral had minimal value (per the lender) and the sale proceeds are needed for typical business operations, your lender may waive the collateral with no pay down or pay off.

Pursuit’s experienced team is here to help you through every stage of your loan

Remember, with any business debt, you need to let your lender know if you’re planning any significant changes to your business, including selling loan collateral, moving to a new location, or selling your business.

If you’re not sure whether your change counts as “significant,” contact your lender to check. They’ll appreciate that you’re aware of your obligations and will work with you to stay in compliance with your loan agreement throughout your loan term. And if you’re currently exploring loan options, Pursuit can help. With more than 15 different loan options, including a business line of credit, we can help you navigate the loan process to secure the funds you need. Reach out to us today!