Unlike Collateral Down Payments Reduce Overall Business Debt

Unlike Collateral Down Payments Reduce Overall Business Debt

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December 11, 2021

Do you own a small business? If you do, yes, we know the struggle is real, not just for a small business owner like you but even for large-scale enterprises as well.

From managing day-to-day operations to taking care of emergency expenses, let’s face it, there are a lot, and often, it doesn’t matter if you are raking it all in. The truth is, these challenges can be very overwhelming indeed.

It even becomes more complex when it’s about growing and maintaining your new business. Companies would turn to a bank for an unsecured loan or a standby line of credit to deal with such endeavors.

After all, there may be a lot of expansion opportunities you could be wasting just because you didn’t have enough funds to take advantage of them. You’ll need that additional capital perhaps to buy more inventory that will save you on acquisition cost or keep up with high demand, which should be a good thing, right?

In any case, securing a business loan is often the first step to achieving various business goals.

While most seller financing doesn’t require a down payment, unsecured loans involving larger amounts usually do. And if you are planning to secure one for the first time but are daunted by this aspect, we hope to convince you otherwise after reading this article.

Although some may view them as a burden, in reality, there is more to it than just being a difficult mortgage requirement. And if you stick to the end, you’ll learn that they should not be a deal-breaker because they might actually make a lot of business sense, too.

But first, what is a down payment?

down payment

It’s safe to assume that most of you are already familiar with a down payment. In any case, we will define it here for contextual purposes. The down payment represents a portion or certain percentage of the total asset value paid by the borrower to the lender to secure credit. It is conventionally tendered in cash, check, or electronic payment

This amount is typically shouldered out of pocket by the borrower.

However, one might view it as a counterintuitive practice. Isn’t it applying for a business loan is such because you’re short on funds?

So why do you still need to shell out in the first place? How do you get around it?

What other options are out there? We’ll attempt to answer these questions as we go along.

Why a down payment is important

Down payments can be intimidating, but you need to look at them from the perspective of the financial institution or lending company. While they basically lend you the money you need, your down payment lends them the confidence to do so.

It’s a measure of goodwill that gives your lender the assurance of secure credit and a sign of your commitment towards fulfilling your loan obligations.

The down payment serves as your equity which partially covers the cost of a certain asset. For instance, you buy a car through seller financing for which you coughed up 20 percent of its price.

Essentially, your overall debt will now only be 80 percent of the purchase price plus interest.

From the borrower’s point of view, they can use the downpayment as leverage when discussing their small business financing options with multiple lenders. It goes two ways: either the lender tries to lure the borrower with a zero or low down payment or the borrower takes a better deal when it comes to interest payments by tendering a higher down payment.

The bottom line is, you should evaluate carefully which loan scheme will work best for you

How a down payment differs from a collateral

We now know that down payments are upfront payments that represent a certain percentage of your mortgage. For banks and lenders, collateral, on the other hand, refers to an asset by the borrower that is pawned to secure credit finance. In other words, that asset, in particular, is conditionally held by a lender during the loan term as security for the transaction.

Most banks finance a business endeavor, where the lender requires collateral instead of a down payment. Such is also commonly referred to as a collateral loan or hard money loan. Like a down payment, though, having collateral allows the lender to manage their risk.

At the same time, it also strengthens the commitment of the borrower to make good their monthly payments. It is based on the premise that the borrower will not compromise their asset, which essentially short changes them if it is repossessed when the business defaults.

On the other hand, once you’ve fulfilled the down payment, it will not be returned to you when your loan has been paid off, unlike collateral which is reclaimed after that.

Collateral as the down payment

While most down payments are tendered in cash or cheque, there are occasions that an asset or collateral is pledged by the borrower or their family member in their place. Depending on the bank, if you have liquid forms of investment like stocks, certificates, or bonds that match the value of the required down payment, more or less, it takes on that purpose.

For other types of collateral, such as real estate, you will need to get its appraised value, unlike stocks that have a definitive value. This is also an attractive proposition to the lender, offering better rates and a longer repayment period.

When to use collateral as a down payment

There’s a good reason why some borrowers would pledge their property as a down payment for a personal loan. Some assets are tied up to investments which means there are the odds of them producing a greater return.

However, if the borrower decides to liquidate them first, they will have to pay capital gains tax if there is a value appreciation. Hence, they would be better off presented as a down payment outright to avoid extra costs.

You have the advantage of such assets remaining as your property unless you default in your monthly payments.

When does a down payment favor the lender?

Aside from reassuring them, lenders have the option to require borrowers to match up to 130 percent of the down payment value if provided in assets.

For instance, 100,000 dollars comprise 20 percent of the loanable amount of 500,000 dollars. You will then pledge an asset valued at 130,000 dollars instead of just representing 100,000 dollars to get a mortgage.

The extra 30 percent serves as a cushion or additional collateral to cover any fluctuations in value.

The worst thing that happens if the total debt is not paid is that the lender won’t take too much of a hit and may even benefit them if the asset’s value has appreciated.

When does a down payment favor the borrower?

They say that one way to convince mortgage lenders to grant you a personal loan or credit is to give off a vibe that you actually don’t need it. When you can put in the down payment, you can negotiate your interest rates favorable to you. So when lenders offer a line of credit with no down payment or collateral, there’s always a catch, which is higher interest rates.

Saving up for a down payment

We can assume that a business with a positive cash flow will likely fulfill mortgage payments. At the same time, it shouldn’t be too difficult for the borrower to put up a down payment from the outflow funds to purchase a tractor.

You can expect that banks will be all over you, ready to sweeten the pot because it will seem that you are potentially a good client for them.

On the other hand, those who want to have a house of their own should start saving up for the down payment. You can do this by setting aside the difference between your rental payments and your projected loan monthly payments.

Invest these savings in bank products like CDs or an individual retirement account, but bear in mind when you need them for a down payment. This practice prepares you for when you are ready to take out a mortgage from a bank. It also increases the likelihood that you can dutifully pay your personal loan

Where to source your down payment

For those with completed mortgages in the past, you can use the proceeds of a positive equity property as a down payment. Aside from savings, you may also acquire the funds through sales of assets or via DPA (Down Payment Assistance) programs that help home buyers with a low to no interest loan or grant.

The latter option applies to a first-time home loan applicant or those who have not acquired real estate within three years. This program typically works for lenders with whom they have an existing relationship.

Borrowing your down payment

borrowing your down payment

Getting a personal loan for a down payment which you are putting in for yet another loan, seems a double whammy as well as a risky option. Many lenders do not accept this arrangement because they become a second mortgage in the process.

They are not prioritized during liquidation in case the borrower defaults. Nonetheless, borrowing the initial amount can still be your last resort. You have short-term business loans, microloans, lines of credit, advances, among others, to finance your down payment.

If you’re taking out a mortgage for a real estate project, proceed with this option only when you expect a wide profit margin from your business. It is also worth noting that lenders who will loan your down payment will likely be privy to your business cash flow and how they will leverage this type of deal. Hence it would be best if you kept this in mind before going this route.

Why zero down payment schemes can be deceiving

When you think about it, businesses will resort to loans because they don’t have the available funds to support whatever their purpose is, whether buying equipment or having standby lines of credit. It makes requiring a downpayment for a personal loan seem a preposterous idea.

Hence lenders realize that borrowers will be in this type of situation where they cannot put up cash equity for mortgages. As such, some of them will offer unsecured loans where they waive the down payment but at the expense of a blanket lien or a personal guarantee, not to mention a higher interest rate.

Such conditions classify you as high risk and may put your business in a vulnerable position. Nonetheless, below are small business options if you are unable to come up with an upfront payment.

Alternatives when you cannot provide a down payment

Line of credit

This option is not the traditional business loan, but many small businesses use it to supplement their revolving funds. The idea is similar to a credit card with instant access to credit, but only when you need it. However, this usually comes with a high-interest rate.

Equipment financing

Depending on the mortgage amount, equipment financing may work for you to absorb the full amount of your intended purchase. As such, this equipment will be the collateral itself. When the borrower defaults, the collateral is repossessed, and you are normally charged for depreciation costs if applicable.

Term loan

Term loans are the go-to for many small business owners for as long they qualify according to the lender requirements. Often, these loans do not call for a downpayment. While it increases their financial leverage, it is also increasing the equity cost.

Invoice discounting

It is common for small businesses to run into cash flow problems brought about by payment delays, so many would resort to invoice discounting. Under this scheme, unpaid invoices are used as collateral instead of fixed assets. A major drawback of this type of finance is the reduction in profits. It can actually cost you more with several fees attached to it aside from the percentage that the financing business takes from the invoice amount.

Small Business Administration loan

This option comes in different forms, such as microloans, guaranteed loans, 504 loans, etc. SBA microloans don’t usually require a downpayment; however, they might ask for collateral depending on the mortgage amount.

In any case, SBA loans have some of the most stringent underwriting conditions for small business owners alongside extensive paperwork. They also take a long time to process, so you must submit your loan application ahead of time if you consider this option.

How to calculate your down payment

Lenders require between 10 percent and 30 percent down payment from borrowers for small business loans and could be higher by choice. Essentially, you need to prove to your lender if your business deal has great profit potential.

The asset you are presenting as collateral is easily liquidated if you want to have less upfront money.

In the meantime, the following factors determine how much they ask you to put in as a down payment.

Loan term

When you buy a property for flipping it but only requires cleaning and a bit of fixing, which would entail a short term, your down payment requirement tends to be on the minimum side.

Low selling price

There are times when the property is heavily discounted; the lender may even be willing to cover a big percentage of the sale price, requiring you to pay close to zero down payment.

Market health

It’s not enough to secure your personal loan with an asset because that asset should also be able to convert into cash to pay off a mortgage to decrease risk. Other factors involve the location of the asset such that a higher down payment is required if a property is situated in a low-income or risky area.

Credit score

This measure estimates the risk of a borrower not being able to fulfill their loan obligation. Hence some lenders reward small businesses with good FICO by lowering the down payment they need to put in. It places those with a poor credit score as high-risk borrowers who will be quoted higher interest rates or bigger down payments.

Liquidity of asset

Aside from property assets, we know that bank investments such as stock certificates, treasury bills, and the like are acceptable forms of down payment. Hence lenders will consider a much higher value for it because such assets can be sold quickly.

Repeat borrower history

It’s recommended to work with the same lender for your future loans because most of the value your credit history. If you have completed your personal loan without a hitch, they will likely reduce your down payment requirement in your succeeding loan application.

Art of the deal

The negotiating skills of the borrower are also a crucial factor in determining your down payment ask. As such, enlisting multiple financial options will give you the edge and upper hand. It will help present your deal with a higher return to raise the LTV of your transaction.

Unlike collateral, down payments make a significant difference

It is easy to think that making a smaller down payment will be in the borrower’s best interest. After all, it’s not easy to produce the standard 20 or 30 percent, which could take many years to save for.

A low down payment accommodates more buyers in the real estate market. This way, there will still be more money left after nailing a mortgage deal to cover closing costs, improvements, and maintenance on the property, not to mention life emergencies. But remember, there are tradeoffs such as higher interest, additional insurance charges, among others.

Meanwhile, a larger down payment generally equals a lower monthly payment. They also lead to a stronger negotiating power with lower interest rates and reduced debt overall. Your PMI premiums are waived in the process, which costs a significant amount that can only add up to your financial burden.

No one would like to pay for that type of insurance because it only benefits one way: the lender.

The Final Final word

Down payments may seem like drawbacks, yet at the end of the day, they protect the lender and help the borrower save a substantial amount in the long run. You come out of it reaching many of your business goals and ready to take on the next challenge.

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