There are broadly two types of small business loans offered by lenders – secured loan and an unsecured loan. While banks offer both secured as well as unsecured loans, fintech companies specialize in unsecured loans. The main difference between the two involves the pledge of valuable assets.
In a secured loan, a lender will insist on an asset to back the loan. The asset can range from equipment, real estate or any other business asset that has cash value. Lenders procure collateral from the borrower as it helps minimizes their lending risk. The underwriting process conducts the detailed due diligence and helps lenders decide which business units to lend to. While the process involves a study of the inherent financial strength of the business, this does not adequately cover the lending risk of the lender. The business is prone to business cycles and the financial position is subject to change. Hence lenders insist on a valuable asset, the value of which is not prone to severe fluctuations.
Further, in case of an average credit score or failing to meet all the criteria of the lender, the lender may make up for the shortfall by demanding additional asset cover as a mortgage.
However, even business units with a strong credibility situation can end up defaulting on a business loan in case the business hits a low.
Secured loans help lenders protect themselves from potential losses by a pledge on the assets. The default amount can be recovered by liquidating the assets. Lenders often use a loan-to-value ratio to determine how much the proposed collateral is worth.
Business lenders typically accept collateral that comprises:
- Real property: Most lenders accept both commercial and personal property, as real estate’s value often remains the same or increases over time.
- Equipment: This mostly applies to equipment loans where the equipment being purchased is offered as a pledge. Many lenders accept equipment as collateral on unrelated loans as well.
- Inventory: The inventory being purchased can serve to secure the loan, provided it is valuable, expected to be used for business purposes and in a good condition. The lender may require an auditor to appraise the inventory value prior to lending.
- Accounts receivables: This is commonly accepted in case a business unit’s cash flow is expected to be realized from invoices of reputed companies. This is highly liquid collateral and preferred by many lenders.
- Blanket lien: This is a very safe option for the lender, but a high-risk option for the business. In such a case, in the event of a loan default, the lender can take over possession of any business asset. In case the valuable plant and machinery, essential to manufacturing operations are taken over, it can result in a complete shutdown of the business.
- Cash: A cash-secured loan utilizes the business’s bank account as collateral. This is a low risk for the lender as the liquid cash can be easily recovered in case of a default. The low risk translates into a low-interest rate on the secured loan.
- Personal assets: For new business loans, where the business does not have a considerable asset pool, the lender may accept the personal assets of the business owner example, home, care or investments. However, this is a risky proposition for the promoter, in his individual capacity, as in case of a low in the business, he might end up losing all his personal savings, which could turn out to be adverse and cause his personal bankruptcy. Hence ideally personal and business assets should be kept separate.
Since all assets are not similar in nature or value, there are certain assets that will not be accepted as collateral. Assets that lose significant value over time or is difficult to trade in for cash, would be rejected by lenders. For example, one can’t secure a loan with computers or software, because of how quickly electronics depreciate in value.
Lenders typically insist on collateral worth the value of the loan being extended, with being over 100% in certain cases. There are several factors that impact the amount of collateral cover required for a loan, including the business operating vintage, credit track record and financial performance.