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What role does collateral play in SME Loans?

Posted: 26th October, 2021

Updated: 8th February, 2023

Written by -

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The increasing number of businesses in India has had an evident impact on the GDP. SMEs have mainly contributed to this rise in GDP. Not only has this sector been helping the GDP, but it also contributes to generating employment for many. While running a small business, getting the best possible out of the available resources becomes imperative. However, sometimes this might not be enough to run the business smoothly. These SMEs require funding at various stages like business initiation, managing operations, capital expenditure, and recovering from losses.

In such cases, borrowing a certain amount can go a long way. Although there might be many ways to go about it, the best remains to be SME Loans.

Banks and financial institutions have also significantly increased their focus on the small business sector credit, acknowledging the role of this sector in the economy. However, lack of awareness regarding this causes a hindrance for entrepreneurs to avail credit.


Collateralized Credit

Financial institutions offer a few loan schemes that have tangible security backing with a business loan. These loans are cost-effective as the interest rates can be adjusted given the reduced credit risk due to collateral security in the case of fraud. These are called Collateral Based Business Loans.

There is a wide range of collateral that you can use to avail loans. These can be classified into the following major groups:

  1. Financial assets like savings accounts, bonds, stocks, debentures, etc
  2. Real estate like residential, commercial, manufacturing units.
  3. Movable assets, e.g., machinery, inventory
  4. Intangible assets, e.g., patents, trademarks, copyright, etc
  5. However, real estate remains the most preferred.

A significant role that collateral plays in reducing the credit risk is in four different ways:

  1. 1. Lessen Adverse Selection - One of the problems that lenders face is that they lack clear information about the actual extent of risk a loan application contains and the guarantee of the borrower repaying the loan amount. In such a case, providing a high level of security against a loan acts as a good signal to ensure that the borrower will make repayment on time, and hence it is a low-risk application. Offering a high level of security also helps the borrowers to stand out from the mixed group of applications.
  2. 2. Lessen moral risk - Another problem that the lender faces is if the borrower uses the loan amount for purposes not stated, which are riskier than the specified in the loan application. In this case, the collateral set aside will ensure the lender that the repayments will be made as specified. This also works as the high-risk borrowers are requested significant levels of collateral, whereas low-risk borrowers are expected to provide a comparatively lower level of collateral.
  3. 3. Lessen losses - Collateral plays the function of compensation for the lender's losses if there is a default in the loan payment by the borrower. In this situation, the banks or financial institutions can forfeit the assets put up as security and recover the amount by selling these off.
  4. 4. Lessen systematic risk - In case of default of loan repayment, the bank, to recover the losses, might sell off the assets put up as security. If the collateral is sufficient to cover the loan’s total value, the lenders won't suffer losses. The banks will be able to fulfill their responsibilities. It is especially important for banks when they need to return funds to their depositors at the time of withdrawal of their money. If the bank suffers losses and is unable to settle the withdrawal requests of its depositors, this might have knock-on consequences in the whole financial sector.

Here are a few things that you must know to avail cost-efficient collateral based business loans

  1. 1. Clear and marketable title of the security

    Lenders make sure that there is a clear and marketable title to the security offered as collateral. Suppose the borrower is offering residential property, the financial institution checks for all the property documents for authenticity, then only they take custody of the original title document of the property.

  2. 2. Loan-to-value Ratio (LTV)

    Since the loan is given based on the requirement, creditworthiness, and cash flow, the upper limit is dependent on the market value of the collateral. The loan-to-cost ratio is the proportion of collateral against which the bank or financial institution will be willing to give a loan. This ratio strongs between 70-85%. Hence, the borrowers should choose suitable assets in line with the funding requirements.

  3. 3. Right business protection

    The criteria for business loan sanction also include the business cash flows. Hence, business owners should make sure the projections are realistic. Good collateral, without a profitable business, might not get the loan sanctioned.

  4. 4. Carefully choose the loan tenure

    The SME business loans cash will be availed for long-term. But, the business owners must look for repayment options for enabling clauses of partial or full prepayment of loans. In case of additional cash flows, these can be used to prepay the loan to reduce the debt and interest rates.


Conclusion

Applying for an SME Business Loan is a very easy and convenient process and can be done online or offline. Backed business loans have many collateral benefits like improved asset liquidity, growth, asset diversification, etc. Still, certain things are to be taken care of while taking a business loan. One needs to wisely choose the loan requirements, the collateral, and the tenure of the loan.

Shriram Finance provides expert and specialized services in retail, Micro, Small, and Medium Enterprise (MSME) lending. Shriram Finance Collateral Based Business Loan offers faster and secure processing with competitive interest rates and flexible tenure. It provides you with easy accessibility and easy repayment of the borrowed amount.

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