One of the key challenges that MSMEs in India face is shortage of funds. It adversely impacts the company’s growth and expansion plans. In such situations, MSME business loans can help fulfil the company’s aspirations.
There are various kinds of loans available for MSMEs depending on the purpose, industry, etc. Though there are different kinds of loans for businesses in India, they can broadly be divided into – collateral and non-collateral loans.
What is a collateral loan?
Collateral loan is a type of secured loan wherein the borrower pledges an asset such as property, vehicle, financial securities, etc. to seek loan. The loan value depends on the value of the collateral or mortgaged asset. Lenders prefer collateral loans as the asset can be liquidated in case the borrower is a defaulter. Collateral loan’s interest rate is usually lower plus a higher loan amount can be obtained as compared to a collateral free loan as the security is involved.
Following assets can be pledged as collateral for a business loan
- Commercial or personal property
- Machinery or equipment
- Investments such as mutual funds, fixed deposits, bonds, etc.
- Insurance policy
Additionally, there are few NBFCs that offer business loan against gold jewellery too.
Why do banks or lenders demand collateral against loans?
Collateral acts as a security against the loan amount. If a borrower does not repay loan, lender can liquidate to make up for the losses. Due to this fact, lender’s risk reduces. Therefore, banks and NBFCs demand collateral against the loan.
Advantages of collateral loan
Opting for collateral loan has various advantages:
- Collateral acts as a security that further helps you to enhance your eligibility in case you have a low CIBIL score or have lesser credit history.
- In case you have less credit history, you can build your credit score by making timely payments of the collateral loan
- You will be able to secure more loan amount as compared to collateral free loans
- You can enjoy lower rate of loan interest as compared to collateral free loan
Disadvantage of collateral loan
- Foremost disadvantage is that there is chance of losing the asset pledge in case you do not make timely payments.
- Since the loan procedure involves additional step of valuation of assets, it usually takes longer time compared to collateral free loans
Collateral vs non-collateral loans
|Collateral loan||Non-collateral loan|
|Needs collateral||Does not need collateral|
|Lower interest rate||Higher interest rate|
|Tenure can be higher depending on the loan amount and collateral||Tenure is lesser as compared to the collateral loan|
|Documentation is higher as original documents related to the pledged asset need to be submitted||Documentation is normally lesser|
|CIBIL score is not the major considering factor. However, higher score adds to the creditworthiness and increases the chances of loan approval.||CIBIL score need to be higher as it indicates creditworthiness|
Examples of collateral business loans
- Property as a collateral: Many borrowers mortgage existing personal property to secure loan. Alternatively, borrowers can also secure a loan against the commercial property that they are buying. Lenders prefer real estate as a collateral because the value generally appreciate over period of time while other tangible assets depreciate. While pledging your personal property like house, you need to be extremely careful. If you default, you will lose the house too. On the other hand, if you are pledging your commercial property and if you default, the lender will seize your property. This will further lead to business losses.
- Machinery as collateral: It is when you pledge a new or existing machinery or business equipment as a collateral. From the borrower’s perspective, it is safer to pledge machinery than the family house. On the other side, your loan amount may get affected depending on the condition of your machinery. If your machinery is too old, gone under wear and tear multiple times, then you many not be able to get loan against it.
- Vehicle as collateral: You can pledge either your personal or commercial vehicle. Sometimes, while getting loan for buying a new commercial vehicle, the same vehicle is pledged.
Documents required for collateral loans
Here is a list of commonly required documents for loans in India (including MSME loans and loans with/without collateral). However, the documents required may vary depending on the lender and the kind of loan applied for. Some of the regular documents required for availing a business loan in India are:
- Duly filled application form
- ID and address proof of the business owner i.e., Aadhaar card, Passport, Voter’s ID card, etc.
- IT returns documents
- GST certification
- Last 2 year’s balance sheet of the company
- Asset’s documents in original as well as photocopy
It is advisable to check with the lender on documents, accepted collaterals, loan amount, loan tenure, interest rates and other details before applying for a loan, to avoid any sudden surprises.
Here are some frequently asked questions about collateral loans.
1. Where can I get a collateral loan?
All banks and NBFCs offer collateral loans. However, the terms and conditions differ from institution to institution. Therefore, it is recommended to check with your lender. It is best to get in touch with at least 3 banks or NBFCs to check criteria, eligibility and terms so that you can choose the one that suits you.
2. Do I need to have a good credit score to obtain a collateral loan?
Banks usually insist on a minimum credit score for loan processing. A good credit score of 750+ is always recommended. However, if you have a lower credit score (e.g., 600+) but can offer collateral as security, it works. Better CIBIL score proves your creditworthiness and you stand a chance at getting a better deal on the loan offer. On the other hand, if you are taking your one of the first loans and do not have any credit history, timely repayment of collateral loan can help you to develop a good score.
3. What is rate of interest for collateral business loan?
The interest rate on business loan depends on various factors lenders, amount of loan required, scheme that the borrower is availing, value of collateral, creditworthiness of the borrower, etc. Generally, it starts from 10% and goes up to 22%.
4. Collateral loan or collateral-free loan, what should I choose?
It depends on various aspect – mainly the loan amount you require. You need to be smart to choose the right loan for your business. In case your required loan amount is higher you can opt for a collateral loan if you have a collateral to pledge and are confident that you can repay the same. In most cases, you will be eligible for higher loan amount as compared to the collateral-free loan. However, value of the collateral dictates the loan amount. In case, the required loan amount is lower, and you are eligible for a non-collateral business loan, you can opt for the same.
Collateral loan is a suitable choice for business owners who have an asset to pledge, loan requirement is higher or need quick approval. The lower rate of interest will lower the EMI and hence repayment will be easier. However, many a times, small business owners do not have collateral to pledge, and hence opt for non-collateral loans. In case the approved loan amount does not match the required amount, business growth may get hampered.