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What are the hidden costs of using personal collateral?

Pledging a personal asset, such as a home or investment portfolio, as collateral is a common requirement for many franchise loans.

Providing your personal collateral as security on a loan minimizes a lender's exposure to risk and may help you secure financing. Of course, doing so puts you in danger of losing the asset if you default on your loan.

"If you're securing Small Business Administration (SBA) financing, it's standard operating procedure for the lender to fully secure all available collateral," says Joe Wong, a franchise finance specialist at ApplePie Capital. "If the equipment that is being financed does not fully secure the loan, the loan must be secured by a second lien on your house, an abundance of cash or marketable securities."

While conventional lenders may not enforce rules regarding loan collateral in the same way, in all likelihood, they too will require some form of guarantee.

"It's also essential to consider how tying up assets as collateral may prevent you from executing your preferred strategy in the future...."

The pros and cons of using personal collateral

You may find it easier to get approved for a franchise loan if you choose an option that requires personal collateral. Using collateral can also help you overcome the challenges presented by a poor credit history. Additionally, the indemnity collateral may allow you to borrow larger sums of money than with an unsecured loan. Gaining access to specialized loan products such as SBA loans also means the chance to qualify for lower interest rates and more beneficial terms.

That said, it's important to understand the hidden costs of going this route. Beyond the risk of losing the assets you put up as collateral, your financial liability will follow you around until the loan is fully repaid.

"[Using collateral] seems like it's not that big of a deal, but life ends up happening," Joe says. "You do things like decide to sell your home, but there's a secondary lien on it, which means that lien has to follow to the next house if you buy a new home. Or if there's a certain amount of profit associated with that sale, you have to pay down the loan commensurate with that amount."

Collateral may impact future growth

It's also essential to consider how tying up assets as collateral may prevent you from executing your preferred strategy in the future, particularly if you intend to open additional units.

"If you're pledging securities or cash, and you plan to own more than one franchise location, the money you put up as collateral will not be available as a down payment for the next location, and that will inhibit your growth," Joe says.

Consider how best to use your assets when borrowing a franchise loan.

Alternative loan options exist

Keep in mind it's possible to find loan options that do not require you to pledge collateral.

"ApplePie's Core loan product does not require personal collateral," Joe says. "What we'll do is execute a lien on the business solely, so the business is the only thing providing collateral to the transaction."

While this still puts an important asset at risk, if frees you up to use your other resources without risk of losing them in the event of a loan default.

Understand the end results

The decision of whether to use personal collateral must come down to your unique financial profile.

In some cases, doing so may be the right, or only, choice. Secured loans such as those provided by the SBA come with multiple benefits, including the opportunity to leverage smaller down payments and lengthier repayment terms.

However, don't forget that pledging collateral may limit your financial options moving forward, and ensures your monetary culpability remains front and center for the foreseeable future.

Begin by exploring your current financial position, as well as how different loans may help you minimize your financial risk while keeping your franchise business growth options open in the future.

Consider your ultimate franchising goals. From there, analyze your options and weigh the pros and cons of each based on your specific situation.

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