Small and Medium Enterprises are booming in a myriad of sectors across the country. They have increasingly become the backbone of the economy and play a crucial role in the urbanisation of rural India. Despite their remarkable contribution, small businesses are not able to flourish due to various reasons, the most important one being Financing.
Finance is a crucial resource to bring great ideas to life, sustain it, and to attain their full potential. At times it can be challenging to decide which source of financing best suits your business needs and circumstances. However, making the wrong choice here can have a long-lasting impact. Even if you opt for a loan, you also must make a sound choice between a secured or an unsecured business loan.
Here’s everything you need to know before choosing a secured loan or an unsecured loan for a small business.
What is a Secured Loan?
If you have a Secured loan, it implies that the loan is backed up with some item of monetary value, known as collateral. These loans are secured because the lender has the right to seize the collateral in the event of failure of repayment. This collateral can be of various forms such as – house, inventory, vehicles, etc. It acts as a protection for the lender if the borrower defaults in his payments.
Having collateral is beneficial for both the lender and the borrower. Since the value of the collateral is generally more than the loan amount, the overall transaction becomes less risky for the lender. The borrower on the other side has the advantage of getting sanctioned a higher amount at a comparatively lower interest rate. Hence, to better negotiate with your lender, make sure to calculate an accurate estimate of your asset’s value.
Pros of a Secured Loan for Small Business:
With lower interest rates and a higher repayment period, the terms and conditions attached with a secured loan are generally favourable for the borrower.
In the default case, the lender has the right to recover only up to the collateral value attached, thereby limiting the risk on the part of the borrower
The capability of borrowing large amounts:
To meet the larger needs of your business, you may need a larger amount of financing. It is possible with secured loans, where the higher the value of collateral, the higher is the loan amount disbursed.
Lower interest rates:
Higher the value of collateral, the lesser the risk and lower the interest rate.
Cons of Secured Loan for Small Business:
Non-availability of collateral:
It is prevalent on the part of the borrower to not have defined collateral which satisfies the lender’s conditions or is sufficient to cover the loan amount. In that case, the borrower is not eligible for a secured loan.
Risk of losing the asset:
It’s essential to seek loans that you can repay without any fault because if the opposite happens, the lender may cease your asset.
Initial cost and time:
Collateral valuations and other legal requirements are to be fulfilled before obtaining a Secured loan. It makes the process lengthy and involves the payment of administration fees.
Unsecured loans for Small businesses
Many of the borrowers have the misconception that unsecured loans are entirely the opposite of secured loans, but that’s not true always. Although unsecured loans charge higher interest rates and lending is done based on your creditworthiness, they are generally backed by a “blanket lien” or “personal guarantee”. Hence, unlike secured loans, you need not provide collateral and can still secure your loan by providing a guarantee or lien.
Under a “blanket lien” there is no initial requirement of defined collateral. Thus, in the event of default, the lender can seize all or any of your property, inventory, machinery, etc., up to the value of the loan.
Next, a “personal guarantee” is an agreement wherein if the business you run is not able to repay the loan, the lender can use your bank account, personal property, or other personal assets to recover the remaining balance.
Since this loan involves a higher risk, lenders are generally averse to providing such loans to new businesses or ones with a poor credit record. However, if you have a good credit history, then securing such a loan is relatively straightforward.
Pros of Unsecured Loans for Small Businesses:
Loan amounts may be smaller:
These loans make more sense when you acquire them for small or day-to-day expenses of your business, for which you won’t expose your asset to the risk of repossession.
No collateral required:
No physical asset is necessary to back the loan; instead of personal guarantees are used to secure the loan. Disbursement is done majorly based on your credit history and business income.
Easier to obtain:
The application process involves minimal documentation and no time needs to be spared for asset valuation. It makes the disbursement process fast and quick.
Cons of Unsecured Loans for Small Businesses:
Rates are higher:
These loans being collateral-free, possess high repayment uncertainty. To offset this risk, most lenders charge higher interest rates.
Credit score hampered:
If by any chance, you fail to pay your instalments your credit score will get degraded. It may also lessen your prospects of availing a loan.
Risk of assets:
For loans backed by blanket lien or personal guarantee, in case of default, you may lose your investment.
Key differences between Secured and Unsecured Loans
The choice between secured and unsecured loans depends mostly on your individual needs and circumstances. However, it is crucial to understand the difference between both forms of lending.
|Basis||Secured Loans||Unsecured Loans|
|Collateral||Collateral in the form of House, Inventory, Machinery, etc||No physical is collateral required. Personal Guarantees or Blanket Lien are used.|
|Interest Rate||Lower due to presence of collateral||Higher to offset the risk of collateral-free lending.|
|Size and Tenure||Higher amount with Longer repayment period (15-30 years)||Lower amount with shorter repayment period (up to 5 years)|
|Speed of Disbursement||Slower due to documentation and legal formalities.||Faster with lesser documentation.|
|Examples||Car Loan, Loan against property||Student loan, Credit cards|
Factors to be considered while choosing a loan
Choosing the correct source of financing requires meticulous planning and a proper understanding of the prevailing circumstances. Here are a few key factors that should be considered before choosing a loan for your business.
Consider your needs:
Money needs can vary from time to time, depending on which phase of the business cycle your business is in. One may need financing for day-to-day business, purchasing of machinery, or for expansion of the company. You should make a list of your requirements and then prioritise which of them should be financed with a loan.
Capacity to repay the loan:
Before entering into a loan transaction, it is necessary to access your repayment capacity. Are your profits or cashflows sustainable and steady enough to cover your instalment amount? If not, you may end up losing your collateral.
Evaluate other costs:
Apart from interest payment, there are several other costs associated with loans. These include processing fee, late payment fee, and pre-payment fee, and additional statutory charges. All these clubbed together can substantially increase your cost of borrowing. Hence it is very crucial to understand these charges before entering into a contract.
There are “4 C’s” that lenders use to evaluate your creditworthiness. These include – Capacity, Collateral, Character, Capital. It’s essential to maintain a good track record of all these four elements, or else the lender may reject your application.
Tips to improve your chances of loan approval
A loan application passes through various steps before finally getting accepted. Here are a few tips which you can implement to improve your chances of loan approval.
- Always maintain a good credit score. A score above 750 is considered ideal for getting unsecured loans approved.
- Read the terms and conditions carefully and keep the required documents handy.
- Research and compare the lenders and the interest rate they charge before entering into a transaction. Taking a recommendation from friends or co-workers can be very helpful.
- Pay all your existing debts to improve your credit score. Having high credit card bills can drive down your credit score and dampen your prospects of getting a loan.
Choosing between secured and unsecured loans is not an easy task as both have their weaknesses and strengths. The decision is to be made considering various factors like capacity to repay, purpose of loan, repayment terms, interest rates and other upfront fees etc. In a nutshell, we can say that secured loans are safer and are less impacted by your credit score. If you want a loan with lower interest rates, a higher borrowing limit and, longer repayment tenure, you should opt for a secured loan. However, if you have a good credit history, need a loan of a small amount, and understand the risk of a personal guarantee, you should opt for unsecured loans.
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