What it means
Every loan is priced for risk, and collateral is the most direct way to reduce a lender's risk. If the lender can recover most of its money by selling an asset, the chance of a total loss falls sharply and the rate charged falls with it.
Lenders never advance the full value of collateral. They apply an advance rate, sometimes called a haircut, reflecting how quickly and reliably the asset could be sold: property might support 70% to 80% of its value, new equipment perhaps 70%, and specialised second-hand machinery far less.
Slow-moving stock often supports only 25% to 50%. Secured debt reshapes a company's flexibility as well as its cost.
Once an asset is pledged, it usually cannot be sold, re-mortgaged or moved without consent, and most secured facilities carry covenants requiring insurance, maintenance and regular reporting on the collateral. Breaching those terms can trigger default even when every payment has been made on time.
The distinction that trips people up is between the debt being secured and the borrower being safe. Secured debt is safer for the lender and, in one sense, riskier for the borrower, because default leads to losing a specific productive asset rather than to a negotiation.
A business that pledges its main production line is betting that line's continued availability on the loan being serviced. Business owners should also weigh the difference between company assets and personal ones.
Pledging company equipment keeps the risk inside the business, while pledging a home converts a business setback into a family one, and the interest saving is rarely large enough to justify that on its own.
In practice
Real-world examples.
Example
A bakery finances a $140,000 oven with an asset loan secured on the oven itself at 8.2%, having been quoted 15% unsecured. The lower rate reduces the monthly payment enough that the equipment pays for itself out of the extra production capacity.
Example
A distribution business runs a $1,200,000 facility secured by a floating charge over receivables and stock, with borrowing limited to 80% of eligible invoices. When receivables fall in a quiet quarter, the available limit falls with them, which the finance team plans around each month.
Example
A property developer takes a $3,600,000 construction loan secured by a first charge over the site. Funds are released in stages against surveyor certificates, and the lender's charge covers the land and everything built on it.
Formula
Calculation
Advance amount = Collateral value x Advance rate. Interest saving versus unsecured borrowing = Amount borrowed x (Unsecured rate - Secured rate).
A printing firm buys a press for $500,000 and a lender offers finance at an 80% advance rate, so the loan is $500,000 x 80% = $400,000 with the firm funding the $100,000 balance. The secured rate is 7.5%, giving first-year interest of $400,000 x 7.5% = $30,000. An unsecured business loan for the same $400,000 was quoted at 12%, which would have cost $400,000 x 12% = $48,000. The security is therefore worth $48,000 - $30,000 = $18,000 in the first year alone, at the price of the lender holding a charge over the press.Case study
Seen in the real world.
Ashcombe Cold Storage is an invented business used purely as an illustrative case. It needed $900,000 for refrigeration plant and had two offers: an unsecured facility at 14.5% and a secured equipment loan at 7.9% with a charge over the new plant and a second charge over an existing chiller unit.
The secured option saved roughly $59,400 of interest in the first year on the full amount, which mattered on a business making about $340,000 of operating profit. The founders' hesitation was that the chiller unit was the heart of the operation, and losing it in a default would end the business immediately rather than merely damage it.
In this illustrative scenario they took the secured loan but negotiated the second charge away, accepting a slightly higher 8.4% rate in exchange for the existing plant staying free of any charge. The trade cost about $4,500 a year and left the business with an unencumbered asset it could borrow against in a genuine emergency, which is the sort of judgement secured borrowing always demands.
Watch out
Common mistakes.
- Choosing secured borrowing purely on the headline rate. The rate saving is real, but so is the risk of losing an asset the business depends on, and that risk belongs in the comparison.
- Assuming the lender can only claim the pledged asset. If the collateral sells for less than the debt, the lender usually retains a claim for the shortfall against the borrower's other assets.
- Overlooking the covenants that come with the security. Insurance requirements, valuation triggers and restrictions on selling or moving collateral are conditions of the loan, and breaching them is a default.
Questions
People also ask.
How much less does secured borrowing usually cost?
The gap varies widely, but a difference of three to eight percentage points between secured and unsecured business borrowing is common.
Can the same asset secure two loans?
Yes, through a second charge, though the second lender ranks behind the first and prices accordingly because its recovery depends on what is left over.
What happens to secured debt if the asset loses value?
The loan does not shrink, and many agreements include a loan-to-value covenant that lets the lender demand additional collateral or partial repayment if the ratio deteriorates.
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