3 Reasons Why Collateral Is Necessary For SME Loan

For any business to prosper, one of the mandatory requirements is funds. The flow and growth of a company are nurtured through cash, and without it, everything can fall apart. This is where SME loans or Small Medium Enterprises loans are given to business owners who require capital when they need funds.

Business owners can avail of a small business loan whenever they are low on funds, depending on their capital needs. For this, lending institutions often require collateral in exchange for the funds as an assurance that the business owner will repay the loan in time.

Let us understand why collateral is needed in SME loans.

What is a Collateral?

A collateral is a valuable asset pledged to secure a loan, primarily when a business needs cash. It works as a medium to secure a loan, and businesses of all sizes opt for SME loans with collateral when they require capital for business operations. These are called secured loans and have lower interest rates than unsecured loans.

Furthermore, collateral can be of multiple types, including equipment, inventory, real estate, etc. When a business fails to repay the loan in the said tenure, the lender has the authority to seize the collateral and sell it to retrieve the amount it lent to the business. The main condition is that the business should own the collateral to pledge it as loan security.

Real estate is the most common form of collateral used as security for business loans.

Collateral and Business Loans - How Do They Work?

Applying for a business loan comes with a specific set of conditions.

When you specify the lender the collateral, you must also specify the assets you will be pledging. If the loan applied is to buy an asset, like a vehicle or equipment, it will automatically be secured by your purchase. This is strict until the lender asks for more collateral on your investing asset.

Therefore, when you are providing the documents for a business loan, it will be mandatory for you to sign a lien agreement. This agreement gives the right lender to claim your collateral if you fail to repay the loan on time.

Because collateral has a significant role in SME loans, it is mandatory for a few reasons.

Must Read: 4 Smart Ways to Get Approved for an SME Loan

3 Reasons Why Collateral is Needed In SME Loans

Lending institutions are looking forward to offering business loans to companies and enterprises. The credit risk automatically increases since small enterprises might be experiencing a considerably small annual turnover. The reason collateral becomes mandatory is to shift the risk to a minimum. Some of the other factors why collateral is needed in SME loans are:

1. Credibility of Repayments

The lenders have the authority to sell the asset pledged by the borrower if they fail to repay the loan on time. Because of such a contract signed between the two parties, small business owners find a greater motivation to pay back the loan within the agreed-upon tenure. Hence, the credibility of repayment of SME loans is established.

2. Understanding The Borrowers’ Background

Lending institutions also look at the collateral as a means of understanding the borrower’s ability to repay the loan. They may also base their selection or approval of the loan on the collateral provided. This implies that higher-valued collaterals can get approval quicker than other assets pledged. This is another reason why collateral is needed in SME loans.

3. End-Usage 

Lending institutions have a tough time understanding borrowers' intentions, mainly when they use the availed loan for purposes they didn’t specify while applying for the loan. The credit risk for the lender rises in such cases. Thus, the lenders ask for collateral that has a higher value than the loan amount to spare the end-usage risks.

Conclusion

As a small business owner, SME loans prove to be a blessing in times of capital crunches. SMFG India Credit understands the financial requirements of SMEs and offers them a lending solution that aligns with them.

SMFG India Credit offers business loans to small businesses for up to INR 75 Lakhs* at attractive interest rates depending on multiple factors such as eligibility, net income, locations, etc. Our online business loan calculator gives you an idea of the monthly instalments, too.