Every business is dependent on funds to grow. Whether it’s for funding your next stage of growth, or to keep your business afloat during a crisis, business loans are essential. This is where collateral loans come in.  Businesses can avail loans at any time of financial requirement in exchange of a collateral. The collateral acts as an assurance that the borrower will pay the loan back on time.

In this article, we will discuss what is a collateral loan and the reasons why collateral is necessary to get SME loans.

What is a collateral?

Collateral refers to an asset that a business can use as security against a loan. The asset, to be eligible as a collateral, cannot be pledged against another outstanding loan. Also, the business must own and control the asset to pledge it as security for a loan. While real estate is the most used collateral by businesses, equipment, inventory or company receivables can also be used to get a business loan.

Note: For businesses looking at small-ticket loans there are different types of business loans for SMEs some of which do not require collateral security.

3 reasons why collateral is important when applying for a business loan?

While loans are available for you to grow your business, the credit risk is high in case of small businesses with small annual turnovers. The main reason why collateral is beneficial is to minimise the risk for the lender.

Things to keep in mind before taking a business loan with collateral:

• Inform the lender (bank/NBFC) of the collateral you have and check if its accepted or not
• Ensure the collateral papers are in place and no other loan is borrowed with it; also, it is recommended to pledge business assets only instead of personal property (you will also need to keep the list of loan application documents for the process)
• Use an EMI calculator to understand the approximate loan amount you are eligible for with collateral support

On that note, let us take a look at the three main factors why collateral is needed in SME loans:

Credibility to repay:

In case there is a default by the borrower to return the loan on time, the collateral acts as a security and the lender has the authority to sell the asset to recover the money.

When it comes to small businesses and start-ups, lenders often check the creditworthiness of the borrower. From checking the CIBIL score of the owner (750+) to the financial statements (e.g., P/L sheet, cash flows, balance sheets etc.) for the previous 2-3 years, lenders try to minimise their risks when offering the SME loan with collateral.

Offering a collateral enable lenders to reduce risks. However, not all collaterals are viewed equally:

• Property as collateral: Highly valued asset as value will appreciate over the years (Read more: Loan against propert for business).
• Vehicle as collateral: Low valued as value depreciates; when taking a vehicle loan for business, the vehicle is automatically used as a collateral
• Machinery/equipment as collateral: Medium valued as YoY expenses are involved including repair and maintenance costs (also like vehicle loans, machinery loans are available where the machine is pledged as collateral)
• Receivables: Low-valued and usually used for small loan amounts where an approved invoice can be used against a loan at a small discounted rate

Understanding of borrower’s background:

The type of collateral pledged by the borrower is an indication of his/her ability to repay the loan. Approval of the loan is directly related to the collateral provided. Loans against higher-valued collateral are usually approved faster than other assets pledged.

Lenders take care to understand the borrower’s background and business potential before offering a loan.

For instance, if you have a low credit score, it is unlikely that banks will offer you a loan without a high-value asset as collateral. This will also impact your loan interest rate and loan offer made. With a collateral, you can get better business loan interest rates for your SME and even negotiate on pre-payment terms.

Also, credit scores and business financial history also informs the lender of your creditworthiness and business potential. In general, if your previous financial history is good and you have a collateral to pledge, the possibilities of getting a loan are higher and faster.

Loan usage:

There are cases when the borrower takes a loan citing a particular investment and use it for others not specified during the loan approval. The credit risk of the lender increases in such cases. A high value asset then buffers the lender from possible default in loan payment and helps manage end-usage risks.

For high-value loans, businesses have to declare the purpose of availing the loan – e.g., purchasing machinery, inventory, vehicles, or using funds for business expansion and marketing, or renting/leasing space etc. Many a times, based on the nature of the business or loan usage purpose, lenders may refuse sanctioning the loan. In such cases, with a collateral pledged as asset it is easier to get a loan as risks are reduced.

Pro-tip: Always provide the business plan to the lender with details on financial projections, market size, targeted customers, etc. This will build confidence in your business and also give you the option to negotiate on the loan offer.

Can you get a business loan without collateral?

Yes. You can get a business loan without a collateral. Most lenders today offer collateral free loans that require no security. SME loans without collateral or security offers a lot of opportunities to entrepreneur and startups to invest and grow their business. The maximum collateral-free loans amount can be availed is usually up to ₹2 Crores, though it varies from lender to lender.

The government of India has been promoting small scale industries and startups and have introduced various collateral free loan schemes to facilitate the same. Some of the collateral free loans by the government are listed below:

• MUDRA Loan under PMMY
• Stand-Up India Scheme
• Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE)
• Market Development Assistance Scheme for MSMEs
• Coir Udyami Yojana

To sum up: How to secure a loan for your emerging business

Obtaining a loan for your business could be a challenge, especially if you do not have a collateral to pledge. However, there are several government initiatives that sanctions loans to businesses without collateral. When deciding on a loan, you must carefully study the parameters that work best for you and the business, and the documents required to secure the loan.

In case you need assistance to decide and apply for a business loan, you can reach out to Tata nexarc that offers attractive unsecured loans from leading banks and financial institutions in India to meet your MSME’s financial needs. You do not need to visit multiple banks to find the lowest interest rates, repayment and EMI options. You can also compare the rates of various lenders and find the right option for your emerging business on the Tata nexarc platform.

Loan usage:

There are cases when the borrower takes a loan citing a particular investment and use it for others not specified during the loan approval. The credit risk of the lender increases in such cases. A high value asset then buffers the lender from possible default in loan payment and helps manage end-usage risks.

For high-value loans, businesses have to declare the purpose of availing the loan – e.g., purchasing machinery, inventory, vehicles, or using funds for business expansion and marketing, or renting/leasing space etc. Many a times, based on the nature of the business or loan usage purpose, lenders may refuse sanctioning the loan. In such cases, with a collateral pledged as asset it is easier to get a loan as risks are reduced.

Pro-tip: Always provide the business plan to the lender with details on financial projections, market size, targeted customers, etc. This will build confidence in your business and also give you the option to negotiate on the loan offer.

Can you get a business loan without collateral?

Yes. You can get a business loan without a collateral. Most lenders today offer collateral free loans that require no security. SME loans without collateral or security offers a lot of opportunities to entrepreneur and startups to invest and grow their business. The maximum collateral-free loans amount can be availed is usually up to ₹2 Crores, though it varies from lender to lender.

The government of India has been promoting small scale industries and startups and have introduced various collateral free loan schemes to facilitate the same. Some of the collateral free loans by the government are listed below:

• MUDRA Loan under PMMY
• Stand-Up India Scheme
• Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE)
• Market Development Assistance Scheme for MSMEs
• Coir Udyami Yojana

To sum up: How to secure a loan for your emerging business

Obtaining a loan for your business could be a challenge, especially if you do not have a collateral to pledge. However, there are several government initiatives that sanctions loans to businesses without collateral. When deciding on a loan, you must carefully study the parameters that work best for you and the business, and the documents required to secure the loan.

In case you need assistance to decide and apply for a business loan, you can reach out to Tata nexarc that offers attractive unsecured loans from leading banks and financial institutions in India to meet your MSME’s financial needs. You do not need to visit multiple banks to find the lowest interest rates, repayment and EMI options. You can also compare the rates of various lenders and find the right option for your emerging business on the Tata nexarc platform.