If you are gearing up to apply for a business loan, you must have come across the term 'collateral.' While this term may sound a tad intimidating, it's really not. Collateral, regardless of the type of loan you apply for, is essentially a tangible guarantee you pledge to the lender.
You do this in exchange for a loan. This ‘tangible guarantee’ is generally a physical asset, which the lender keeps until you pay off all your EMIs within the stipulated tenure.
So, What is a Business Loan Collateral?
Any collateral or tangible guarantee you pledge to your lender in exchange for a business loan is considered business loan collateral. A key point to note here is that a physical asset already being used as collateral against another loan cannot be pledged to secure a business loan. The guarantee or collateral you wish to pledge must be a no-strings-attached asset.
Securing a business loan against collateral is called a secured business loan. In certain cases, a borrower may also qualify for an unsecured business loan. These loans are sanctioned without any collateral and are usually loans of smaller amounts. They are given only after careful vetting of borrowers.
Importance of Collateral in Business Loan Applications
There are two reasons why pledging collateral is important while applying for a business loan.
1. Raises Credibility
If you secure a business loan by pledging collateral, you essentially increase your chances of securing a business loan; that, too, at relatively low-interest rates and negotiable tenures. Pledging collateral helps the lender grasp the repayment capability of the borrower. It forges trust between the lender and the borrower.
2. Reduces Systemic Risk
Both borrowers and lenders can take comfort in the fact that with collateral in view, both parties are shielded from financial and personal complications. If the borrower defaults, the lender can simply liquidate collateral to recover the owed sum and doesn't have to penalise the borrower.
Types of Collateral
So, what qualifies as collateral to secure a business loan? The following five categories work as collateral for business finance.
Real estate – Typically, this includes an owned office space, godown, warehouse, or any other physical property. Borrowers are also free to include a non-commercially owned property to pledge as collateral to secure a business loan. Such an asset could include an apartment purchased as an investment or the business owner's residential property.
Equipment: Depending on the type of business, expensive equipment also qualifies as a type of collateral. Such machines would include earth movers, company cars, cranes, computer hardware and even office furniture.
Inventory: This type of collateral includes raw materials or stock lying with the business owner. Raw materials can be of high value depending on the kind of business one owns. Owners often take a business loan to purchase inventory, which is automatically hypothecated to the lender as collateral.
Receivables: A business might be waiting for funds from customers. These are receivables and make for a sound type of collateral if they are outstanding for less than 90 days. Certain lenders may consider such receivables as good as cash.
Company or Personal Investments and Savings: This type of collateral typically include stocks, shares, fixed deposits, mutual funds and other market or non-market-linked instruments a business or individual owns. Borrowers can pledge these as collateral in exchange for availing of a business loan.
Benefits of Using Collateral in Business Loan Applications
Why should I pledge collateral while filing my business loan application? Here are the three key benefits of doing so.
1. Exposes Borrowers to Attractive Interest Rates
One of the key benefits of pledging collateral in business loan applications is that it gives you the agency to negotiate a lower interest rate from your lender. Fret not, the lenders already know that a borrower coming in with collateral to offer is expecting a tempting rate of interest, and in most cases, they oblige.
2. Allows Them to Continue Earning Interest on Pledged Collateral
Just because you pledge collateral doesn't mean the lending institution owns your asset. Remember that you are only mortgaging it to them at the end of the day. It is like a barter of sorts where you loan an asset in exchange for a loan of cash. Therefore, any interest or rental income you earn from the pledged collateral goes into your pocket and never the lender's.
3. Collateral May Reduce Your Down payment
Not only can you negotiate a lower interest rate with your lender, but you can also negotiate better overall repayment terms with them. For example, through pledged assets, you can negotiate a lower down payment and loan tenure.
Considerations When Offering Collateral
As a borrower, you must have two primary concerns when offering any collateral for securing business finance. These are:
How much collateral do I need?
Know that generally, lending institutions lend 80% of the total collateral value. You must include this figure when calculating the amount of loan you need. This will also help you figure out the asset or collateral fit to pledge.
Safe to say, you should then pledge collateral that is at least 20% higher in value to get the entire amount you need. For instance, if you want a loan worth Rs. 1,00,000, pledge collateral that is at least worth 1,20,000.
Which asset should I choose?
The asset you choose must first match the lender's lending criteria. This means it should be present on the list of collaterals accepted by them.
Secondly, you must pick an asset that is entirely free from any dispute and is not already pledged to another lending entity.
Once you have these two things sorted, feel free to pledge collateral that will optimise your loan amount.
Alternative Options for Securing a Business Loan
What if I don’t match the lender’s lending criteria? In such a case, it’s critical you know certain alternative options for securing a business loan. These include:
Line of Credit - In this case, your lender may approve a certain pool of money. But here is the twist! You only pay interest on what you use from that entire pool. Small businesses often utilise a line of credit for equipment financing.
Crowdfunding – You may seek funding through sources from your peers, other firms, or over the internet. While this method has occasionally worked for entrepreneurs, they often have to award equity to their peers and firms that lend them money. This leads to a dilution of ownership, which may not work in a business owner's favour.
Venture Funding – Private equity firms or individual venture capitalists are another alternative sources for securing a business loan. However, similar to crowdfunding, venture funding also comes with certain conditions. In addition to the dilution of ownership, you may also have to let your investors take part in decision-making for your business.
Conclusion
Have your collateral all figured out but can't find a suitable lending institution? Your search ends at Tata Capital. We offer business loans at affordable interest rates, relaxed lending criteria, negotiable tenures and minimal documentation.
To know more about our business finance offering, or start an online application, give us a call or visit our website right away.
28 February 2023
7 mins read
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