Most business loans in India are collateral-free loans, allowing small businesses without significant assets easy access to financing. However, if you need to borrow a substantial amount of capital for business growth and expansion, you may need to opt for a secured business loan with collateral. Similarly, if you are applying for business credit with a poor credit score, you may not qualify for unsecured loans. In such cases, you will have to leverage different types of collateral to secure the funding. In this article, we explore what is a collateral loan and what are the different types of collateral accepted for business loans in India.
What is Business Collateral?
Business loans with collateral are secured loans, where the pledged asset lowers the risks associated with lending. A business loan collateral is an asset the company offers as security to the lender. In simple words, business collateral is an asset that’s pledged to obtain a loan from the lender. The lender reserves the right to seize this pledged asset if the business owner defaults on the loan. Therefore, the collateral security for the loan acts as an additional safety net for the lender, often allowing entrepreneurs to secure loans at lower rates of interest and better repayment terms.
Most lenders have policies and guidelines that dictate the list of acceptable types of collateral. A few common types of collateral used to secure a business loan are listed below:
- Residential or commercial property
- Business equipment
- Inventory
- Invoices
When you apply for a business loan with collateral, you need to sign a lien agreement with the lender during the loan agreement signing process. This lien grants the lender the right to take control of the pledged asset in case of a loan default.
Common Types of Collateral for Business Loans
Lenders have different eligibility requirements when it comes to business loans. As a result, the list of assets accepted as collateral for a business loan also varies. So, if you are looking to obtain a secured loan, you must under the different types of collateral needed for a business loan:
Real Estate
Real estate is one of the most common types of collateral used to obtain secured loans. Acceptable real estate collateral include personal properties like your home, commercial properties, or even land. Lenders prefer real estate collateral primarily because the value of real estate tends to appreciate over time. This ensures greater safety for the lender, especially on long-term loans or larger amounts of financing.
Investment, Jewelry, and Other Valuables
Business owners can also pledge their investments, gold jewellery, and other valuables as collateral for a business loan. Most banks accept investments like stocks and bonds as collateral because these instruments can be easily liquidated to redeem the loan amount. However, these assets, especially stocks, can display intense price volatility, which may impact the loan terms. However, pledging gold and gold jewellery as business loan collateral can be risky because you run the risk of losing these personal assets in the event of a default. Additionally, gold collateral is evaluated on the basis of the purity of gold and the one-time making charges are not included in its valuation, resulting in a lower loan amount.
Machinery and Other Depreciating Assets
You can also obtain a secured business loan with collateral by pledging tangible business assets like machinery, computers, or printers. Since these assets are indispensable to the daily operations of the business, they make good collateral options. However, this type of collateral comes with a drawback. Lenders may not be willing to sanction high loan amounts since business equipment tends to depreciate over time. Moreover, lenders may not accept certain types of business equipment as collateral if there are limited buyers for the equipment in the market.
Bills Receivable
The money owed to your business by customers can also be leveraged as a business loan collateral. Instead of waiting for the customers to pay, you can use the bills receivable as collateral and access immediate working capital. Pledging bills and accounts receivable as collateral for a business loan is a good option for businesses with strong sales but slow payment cycles. The lender considers the value and reliability of the bills receivable to grant you credit against the outstanding invoices and bills. However, opting for this type of collateral results in fees payments, whereby you earn less money than what you would have received upon direct payment by the client.
Inventory
Product-based businesses can use their inventory stock as collateral for a business loan. Your inventory stock can include raw materials as well as finished goods. Lenders sanction the loan amount based on the market value of the pledged inventory and the ease of liquidity involved. However, you must note that some lenders may not accept inventory as collateral for a secured loan because of the difficulties involved in selling the stock. Pledging inventory is also risky since if you default on the payments, you will lose your stock as well as your ability to generate profits.
How Much Collateral Do Business Lenders Require?
Now that you understand the various types of collateral accepted for a secured business loan, let’s review how much collateral is actually needed to obtain the loan. Simply put, the amount of collateral needed to obtain a secured business loan depends on various factors including the policies of the lender, type of loan, the creditworthiness of the borrower, and the associated lending risks. Lenders sanction secured business loans on the basis of the LTV (loan-to-value) ratio. The LTV ratio is a simple metric that compares the loan amount to the value of the business loan collateral offered by the borrower. Depending on the policies of the lender and the type of collateral pledged, LTV ratios can vary from 50%-80%. Lenders may be willing to sanction higher loan amounts if the borrower has a high credit score and the pledged collateral is a high-value one. Common LTV ratios for various types of collaterals are listed below:
- Real estate: The LTV ratio typically ranges from 70%-80%.
- Machinery: The LTV ratio ranges from 50% to 75% based on the age and depreciation of the asset.
- Bills Receivable: The LTV ratio for bills receivables depends on the creditworthiness of the customer. It typically ranges between 50%-70%.
- Inventory: The LTV ratio for inventory financing ranges from 20%-50% since the inventory stock will likely lose value over time.
Eligibility Criteria and Documents Required
If you are thinking about applying for a secured business loan with collateral, you must meet the lender’s eligibility requirements. Generally, this includes meeting the minimum business vintage, minimum credit score, and minimum annual turnover requirements. Additionally, the value of the collateral your pledge must be able to cover the loan amount you wish to borrow. Other than that, lenders may also have other requirements.
To obtain the secured business loan with collateral, you must submit the following documents to prove your eligibility:
- KYC documents like your PAN Card, Aadhaar Card, or Passport to prove your identity.
- Financial statements of the business including profit and loss statements, ITRs, and audited balance sheets to demonstrate its financial standing.
- Proof of business ownership like registration papers, licences, incorporation papers, partnership deeds, etc.
- Bank statements from the last 6 months.
- Ownership papers for the business loan collateral like property deeds of the real estate you wish to pledge.
- Collateral appraisals from professionals to verify the value of the asset.
In Closing
Collateral business loans are a valuable source of financing for businesses looking to secure substantial credit to fund growth and expansion operations. Businesses can leverage collateral options like real estate, inventory, investments, equipment, and accounts receivable to obtain credit at a lower interest rate. Since pledging a collateral lowers the risk for the lender, business owners with a strong revenue stream can effectively lower their cost of borrowing while retaining ownership of the pledged assets through timely payments. Understanding the various types of collateral, LTV ratios, and the documentation needed to prove eligibility can help business owners approach lenders with a well-formed strategy.
