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Pledging A House for a Secured Business Loan Can Open the Door to Trouble

By Elena Malykhina

Small businesses are responsible for a significant amount of all business borrowing, whether for starting up or supporting growth, according to the U.S. Small Business Administration (SBA).1 But small business borrowers often face real challenges: The SBA also found that small business owners are likely to fund the business via credit card or pledge personal assets to secure business loans. One prime example: putting up a home as collateral.

Using a home to secure a business loan is such a common practice, according to an article in Inc. magazine, that the housing bubble bust beginning in 2006 created a “significant roadblock for small businesses seeking small business loans.”2 New businesses tend to opt for secured business loans using an owner’s primary residence as collateral because they appear to be a smart choice, notes financial advisor Sam Thacker writing in AllBusiness.com.3 The reason: “Many borrowers, especially start-up borrowers, may have most of their net worth tied up in their residence,” he says. The problem, Thacker points out, is that the practice causes small business owners to risk not only financial ruin, but homelessness, as well.

 

It is for the lenders that secured business loans with a home as collateral is a smart choice – so much so that it has become a de facto part of small business loan terms in some areas, according to Thacker’s article. But at least one state – Texas – has outlawed the practice, recognizing its danger.4

 

It’s also worth noting that using a home as collateral for a secured business loan is not free. Business loan requirements may cause borrowers to pay high and non-refundable upfront costs associated with “collateral valuation,” the process of determining the market value of an asset by a qualified expert.5

 

A borrower that uses his or her home as collateral and cannot pay back a secured business loan is likely in for trouble.6 Defaulting on such a loan really can leave the business owner homeless, since the lender’s “security” is that it has permission to seize and liquidate the asset.

 

So, what alternatives to secured business loans are there that don’t involve possible homelessness? There are several. Some of these alternatives can be expensive or involve high interest rates, so small business owners may need to search to find the best match for their needs.

 

Alternatives to Secured Business Loans

 

Unsecured loans are a good financing option for small business owners who don’t want to secure a business loan with their home. However, very few lenders offer fully unsecured business loans – sometimes known as “signature loans” – requiring no collateral or personal guarantee.7 Most often, lenders that offer such loans protect their investment in other ways that are costly to the borrowing business, such as charging higher interest rates than a secured business loan. Moreover, a borrower’s ability to obtain an unsecured business loan directly depends on their credit score.8

 

For businesses looking to avoid high interest rates, merchant financing is another option. The term refers to a type of funding available only to businesses with storefronts and a credit-card processing system.9 A business’ ability to obtain merchant financing is dependent on the average daily value of its credit-card transactions. Merchant financing is based on a fixed fee – not an interest rate – and daily automatic repayment. Merchant financing lenders set up a system in which they take a daily percentage of a company’s transactions. Merchant financing involves short repayment terms – typically six-, 12-, and 24-month periods, and the lending secured by business, not personal, assets.10 Businesses considering this option must be able to manage large and frequent payments – if a company falls behind, the lender can increase the repayment rate.

 

For borrowers that have no collateral, no personal security, and no trading history, equity financing is a way to raise money – i.e., look for investors. Instead of securing a business loan with assets, investors provide capital in exchange for ownership in the business. (This kind of investment is the basis for the TV reality show, Shark Tank.) Equity financing can include money from friends and family, small business investment companies (such as those regulated by the SBA), angel investors, and venture capital firms.11

 

Individual investors can also provide funding to companies through peer-to-peer (P2P) lending, sometimes referred to as social lending or crowdlending. Businesses can bypass financial institutions as intermediaries, but the process involves more time, effort, and risk than traditional loans.12 In P2P lending, a loan might have multiple sources and monthly repayment must be made to each of the individuals.

 

Crowdfunding is another option for businesses that are just starting. It’s more of a grant than a loan, and it allows companies to promote their products and services while building a following via social channels. Business owners set up a crowdfunding campaign online, and interested parties contribute money, often in exchange for expected products or company assets in the form of rewards or equity.12 While crowdfunding can be effective in generating startup capital, it’s not typically used for long-term business financing.

 

The

Takeaway:

Entrepreneurs passionate about starting a new business can be tempted to post their homes as collateral for a secured business loan. Demanding such high-value collateral has become a routine practice on the part of many banks. But there are many alternatives small business owners may wish to explore before putting their homes at risk.

Elena Malykhina

The Author

Elena Malykhina

Elena Malykhina is professional writer who has covered science, technology and business for more than 10 years. Her work has appeared in InformationWeek, Scientific American, Newsday, The Wall Street Journal and Adweek, as well as through the Associated Press.

Sources

1. “Small Business Finance,” U.S. Small Business Administration; https://www.sba.gov/sites/default/files/Finance-FAQ-2016_WEB.pdf
2. “5 Tips for Using Collateral to Secure a Small-Business Loan,” Inc.com; https://www.inc.com/guides/201101/5-tips-using-collateral-to-secure-a-small-business-loan.html
3. “Is Using Your Home as Collateral on a Business Loan a Good Idea?,” AllBusiness.com; https://www.allbusiness.com/is-using-your-home-as-collateral-on-a-business-loan-a-good-idea-14087948-1.html
4. Ibid.
5. “3 Common Problems When Applying for Secured Business Loans — and How to Solve Them,” National Business Capital; https://www.nationalbusinesscapital.com/secured-business-loan-problems
6. “The Top Secured Business Loans For Your Small Business,” Fundera; https://www.fundera.com/business-loans/guides/secured-business-loans
7. “What Is a Signature Loan?” Experian; https://www.experian.com/blogs/ask-experian/what-is-a-signature-loan
8. “Unsecured Business Loans - Your Top Options in 2018,” Fundera; https://www.fundera.com/business-loans/guides/unsecured-business-loans
9. “Merchant Financing: What It Is and How to Find It,” Fundera; https://www.fundera.com/business-loans/guides/merchant-financing
10. “What’s Merchant Financing?” American Express; https://merchantfinancing.americanexpress.com/merchantfinancing/faq.htm#repayment
11. “6 Types of Equity Financing for Small Business,” The Balance Small Business; https://www.thebalancesmb.com/types-of-equity-financing-for-small-business-393181
12. “Peer-To-Peer (P2P) Lending,” Investopedia; https://www.investopedia.com/terms/p/peer-to-peer-lending.asp#ixzz5DVS1qtJO
13. “Crowdfunding for Business: What You Need to Know,” NerdWallet; https://www.nerdwallet.com/blog/small-business/crowdfunding