Here is How Unsecured Loans are Different from Secured Loans

Adequate funding is a pre-requisite for any business. Whether a project is at its initial stage or in the development phase, it needs ample financial backing to keep up its growth momentum. However, finding adequate funding can be a challenging process despite the market now offering a wide range of alternatives to traditional sources of finance.

In their search for funding options, start-ups and small businesses often stand at crossroads where they must choose between secured and unsecured loans. On the surface, both look “equally attractive” with their respective advantages. Borrowers are frequently perplexed as to which should be their final choice.

It is therefore important to delve more deeply into these two broad categories of loans and compare their costs with the benefits they bring. Businesses must also be aware of their own financial situation to understand clearly which loan option they will be eligible for.

Let us first understand the basic concepts of secured and unsecured business loans in India.

Secured Loan

A secured loan is always backed by assets. While applying for such a loan, the business must own something of measurable financial value, which can be offered as collateral to the lending institution. This could be an immovable property (a plot of land with or without construction), gold, a valuable investment portfolio, or any other asset that can be liquidated. Businesses can also extend their machinery, raw material or inventory stock as collateral.

The collateral has to be pledged to the lending institution. This implies that the lender will hold the title/deed to the collateral until the loan is fully paid off. However, the borrower retains the ownership of the asset and will continue to enjoy benefits accruing from it.

If the borrower fails to pay off the loan in the stipulated time, the lending institution has the right to take over the possession of the collateral and sell it to recover the outstanding debt amount. Typically, with secured loans, the end use of funds borrowed is pre-determined.

Advantages of secured loans

Borrowers are often lured to secured loans in the hope that they will be able to procure a larger loan amount than what unsecured loans can offer. The longer period available to pay back the borrowed sum is also a perceived advantage.

Another apparent benefit of these loans is the lower interest rate charged on them. This is based on the rationale of lesser risk involved, thanks to the collateral that can be sold off by the lender in case of payment defaults.

THE CAUTION – What must also be remembered is that some secured loans can have very high interest rates. There are financial agencies that charge the highest legal interest rate for business loans despite taking collateral from the borrower. Reading the fine print carefully is always recommended. In some cases, a low interest rate can also be a promotional or limited period offer that may be withdrawn after a few months.

In addition to non-banking financial companies (NBFCs), nationalised and private banks also offer secured loans to businesses, but the banking penetration in India is still low. This prevents several small and medium enterprises (SMEs) from obtaining a secured loan at a reasonable interest rate.

Another common disadvantage of secured loans is that the process of getting approval is longer and calls for more paperwork than an unsecured loan.

This brings us to the second business loan category.

Unsecured Loans

An unsecured loan is not backed by any collateral. It allows the borrower to get funds without having to offer any asset as guarantee to the lending institution. Generally, unsecured business loans come with a fixed term and fixed rate of interest.

Unsecured loans are offered based on the credit worthiness of the borrower. For an enterprise, the eligibility can be gauged in terms of years in business, its annual turnover and the primary location (city) from which it operates.

The tenure of these loans is often shorter than the long-term loans granted by banks. Most nationalised and private banks approve loans for SMEs with a payback tenure of not less than one year. NBFCs can offer immediate loans for shorter periods. At Capital Float, unsecured small business loans are offered for a tenure of one to 12 months. This gives the borrower the advantage of securing quick funds for sudden needs. Once the project begins to reap returns, the business can pay off the loan and thus avoid paying interest for prolonged terms.

Advantages of unsecured loans

When a business requires only a small amount, an unsecured loan is a better alternative than a secured one, especially if the business does not want to expose its financial assets to the risk of repossession. Also, those companies that do not possess sufficiently valued assets for the amount they require can find easy access to working capital finance with unsecured business loans.

Such loans also act as a good source of funds for companies that are already trading. Since the loan is unsecured, the lenders decide upon its amount by simply assessing the trading position of the business. Background checks are performed on credit history, cash flow position, cash reserves and balance sheet.

Unsecured business loans are quicker to obtain than secured loans. We provide funds to our clients within 3 days once they submit the necessary documents and clear the eligibility criteria. As against this, private banks take more than two weeks in forwarding the grant, while public sector unit banks can take 4-6 weeks for the same.

If your business needs immediate financial support and you are hesitant to offer any collateral to the lender, unsecured business credit will work for your best interests. By choosing Capital Float as your trusted finance partner, you are assured of a quick digital process to submit your application. The entire loan disbursal process is completed in three simple steps, given below:

  • Upload the minimum required documents on our website
  • Receive approval in minutes if your paperwork makes the business eligible for loan
  • Get the funds within next 72 hours

Do not let the long-drawn processes of conventional funding delay the pace of your venture’s development. In the digital age, unsecured corporate loans can conveniently help you accelerate your business growth.

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The SME Lending Puzzle: Why Banks Fall Short

Let us consider the following hypothetical scenario:

ABC & Co., a small services firm, began operations in mid-2011. It reported a 40% jump in annual turnover from Rs. 5 Cr in FY 2012 to Rs. 7 Cr in FY 2013. As a startup, the company has not yet broken even and reported losses for consecutive years. The promoter is well educated, previously worked in organizations of repute for over a decade before deciding to float this venture. The short-term finance requirement of ABC & Co is about Rs. 40 lac for 90 days, but does not have any physical collateral to offer as security. At this stage, the promoter of ABC & Co. decides to approach banks and NBFCs in the market to fund this debt gap.

What would this promoter’s experience be in today’s scenario? Would he be successful in securing the necessary funds?

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According to a recent statistic, 33% of companies operating in the Micro, Small and Medium Enterprises sector have access to banks and financial institutions, while the rest remain excluded and are compelled to raise money through informal channels.

This debt gap is alarming especially in the backdrop of the fact that SME segment contributes nearly 10 percent of the country’s gross domestic product and 45% of all industrial output.

Till date, banks and NBFCs have not been able to finance this debt gap effectively. What has prevented or restricted them from profitably penetrating this sector? Is it due to inherent credit risk in the segment, lack of collateral, government regulation and laws, or simply because there are greener pastures elsewhere to lend money?

Lets us understand the debt requirement of the SME segment (both early-stage as well as mature entities) before we try to further dissect this issue. In our example, ABC & Co. could require financing for primarily two reasons:

1) Capex, i.e. medium to long-term finance for business expansion, product diversification, renovation of business premises, or purchase of machinery.

2) Working Capital i.e. to cover short-term immediate cash flow needs arising from day-to-day business operations.

To cater to this demand, banks and financial institutions already have specific products (both fund and non-fund based) that can be broadly categorized into two categories for the sake of simplicity:

1) Simple lending products, which would typically cater to the first requirement of SMEs for Capex. These are medium to long-term financing products in the form of equipment and machinery loans, high yield unsecured business loans, Loan against Property etc.

2) Specialised lending products, which typically include factoring, trade finance, cash management services, project finance, bank guarantee, or letters of credit, which typically cater to the second requirement of working capital finance.

As is evident from the above, it is not the lack of “products” that explains the under-penetration of finance flowing to the SME sector. Rather, it is in the design, applicability and administration of these products to the SME sector that banks have fallen short.

In an effort to go deeper, we can identify four key reasons among others, for this shortfall:

1)  Sole Focus on Financials: The current approach to SME lending in most institutions is still heavily dependent on business financials- i.e. looking at historical data to predict future creditworthiness. Typically this involves a lot of paper work and many visits to the applicant.

This approach has not been very successful in the SME sector to-date due to the fact that the financials provided by the applicant are often opaque given the cash nature of business transactions and incentives to under report income to save on taxes. ABC & Co., on this parameter alone (aside from business vintage) would be filtered out as the current financial position reflecting business losses would not be very appealing to most financiers.

2)  Bureau Reporting: There are two kinds of credit bureau reports that can be generated by member banks and NBFCs – Individual and Corporate. While individual records are provided by most bureaus, only CIBIL currently provides reports for corporate entities in India. Valid records for SME entities are still not very evolved in the country. And while the bureaus can provide data on credit worthiness of the individuals involved in any given company, they cannot give relevant insights about an applicant who is a first time borrower.

Since ABC & Co. is newly established, there would not be any bureau record on the company. The application would then have to be judged on the strength of the individual records for the promoter as well as the business viability of ABC & Co.

3)  Selective Segmentation: The implication of the above two factors is that only the “upper layer” of the medium to large enterprise segment is able to pass through banks’ and NBFCs’ credit assessment parameters, leaving aside the major chunk of “small” entrepreneurs and entities whose need for adequate finance is more pronounced. These small entities could be major links in the supply chains of large players, and their inability to access finance could have the ripple effects across the value chain.

4)  Lack of Collateral Security: Lending in India traditionally has relied on taking adequate collateral as a “risk mitigant” to cover the credit risks associated with SME lending and the ambiguity around appraising this segment. The Loan to Value ratio (LTV) becomes the yardstick to segregate and approve or reject cases based on risk. This ratio is inversely proportional to the risk perception of the applicant.

Since ABC & Co. does not have any physical collateral such as property or machinery to offer and the promoter has pitched in whatever money he had in the form of initial capital into the business, his application would be rejected by most banks and NBFCs in the market today.

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This problem of access to finance for SMEs in India is even more accentuated for early-stage companies or startups such as ABC & Co. In their case, past financial performance would be not a correct indicator of the future potential of the enterprise. After initial round of equity funding from family and friends or seed investors, working capital requirements or ad-hoc needs for short term finance would inevitably kick in and must be dealt with in a timely manner to keep the firm operational.

To conclude, traditional lending to the SME sector in India can best be described as a “One Size Fits All Approach.” The risk management techniques used by banks and other financial institutions today are invariably more suitable for medium and large corporate entities. The same set of rules when inadvertently applied to small and early-stage enterprises result in a faulty output, i.e. the systemic rejection of most SME loan applications like ABC & Co. Given the intense nature of competition in the lending industry today, the consequence is that too many banks and financial institutions end up chasing the same set of “good” customers, leaving aside a much larger untapped segment of SMEs in the process.

Watch this space for more articles on the subject as well as suggested ways to underwrite “small” and
“early-stage” entities in the SME sector.

(Image credit: http://blog.directcapital.com/misc/small-business-loan-video/) 

Oct 24, 2018

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7 TIPS TO SAVE MONEY WHILE MANAGING PERSONAL FINANCES

In today’s world, saving money is of the utmost importance. If you are stressed about how to save money, then you are not the only one in this regard. Financial planning sounds easier than to practice. Even though it may be more exciting to spend money, you should try to practice saving for contingencies, as the future cannot be predicted and is uncertain.

Why is saving money essential?

Saving money can help you to become financially independent, providing you with security in the face of emergencies. Financial planning is necessary to set aside money for the family’s needs, such as the education of children, marriage expenses, healthcare expenses, planning for significant life events, retirement, etc. Saving money is an effective financial practice and a lifestyle choice with several proven benefits.

7 tips to save money

Though there are several ways to save money, you could consider implementing these seven tips:

  • Awareness: Being aware is one of the most critical factors. If you are aware of your finances and spending habits, you will be able to consciously set more money aside.  
  • Prepare a budget: Begin by identifying your fixed and flexible expenses. This will help you evaluate how much of your corpus is depleted by unnecessary expenditure. After this, you can prepare a budget on a weekly or monthly basis by setting expenditure limits. This will help you pay your bills while simultaneously creating a pool of savings. You can make a budget on a weekly or monthly basis (based on your preference) with spending limits clearly defined. This budget may help you in saving extra money and restricting unnecessary expenditures.
  • Curb the spendthrift in you: Many people aren’t always conscious of how lavishly they spend money on unimportant things. Tracking expenses will help you maintain a close vigil on expenses and keep the spendthrift within under control.
  • Create an emergency fund: While facing emergencies, financial support in the form of insurance or loans may not be immediately available or they may not cover the need of the hour. At such times, savings come in handy to address the contingency. Therefore, make sure you set aside a fund for unforeseen expenses.
  • Sell things you no longer use: There are many things we buy, and after some time, do not use any more. These items can be sold to generate funds.
  • Savings calculator: Various types of savings calculators can be found online. These can be used to calculate the amount one can save over a given period of time. Using these calculators could encourage the habit of saving.
  • Switch to a personal finance money management app: Spends tracking and budgeting can be made easy with personal finance management apps. Walnut is one of the most loved and rated apps in the market with over 10 million downloads. Use this app to unlock the financial planner in you. 

It is necessary to save money, as it provides security, financial independence, and reduces stress. Get started on your journey of personal financial planning to achieve peace of mind and money in the bank for when you need it.

Oct 24, 2018

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Old May Not Always Be Gold

Like most college friends, Ankit, Murthy and Kumanan lost touch with each other soon after graduating. Unlike most friends who lose touch with each other, they ran into each other while vacationing in the same resort at the same time to celebrate new years’ eve. While their career paths had diverged 15 years out of college, they were soon reminiscing the good old days with an equally old bottle of scotch. After rewinding and replaying the past a few times, the conversation caught up with time and they started talking about work.

After several years of working in a traditional bank, Ankit got bored and joined a new age digital lending company as the head of credit. Kumanan worked at large garment manufacturing units in India, Bangladesh and China. Watching the industry disappear around him, he sensed opportunity and had recently started his own T-shirt design and manufacturing company where he was riding the e-commerce boom and sold most of his inventory online. He had ambitions of starting his own brand soon. Murthy had joined his father’s business and expanded a single department store into a chain across the entire city. He also supplied snacks, beverages, toiletries, cleaning equipment to the largest software company of his city and they were constantly demanding that he supply paper, ink and most other consumables as they grew and expanded.

With the scotch taking care of any and all inhibitions, Murthy and Kumanan’s frustrations surfaced and they started talking about how they love their work, the sense of independence, the sense of control over their destiny but how they absolutely hated dealing with lenders and banks. In their mind, Ankit personified this opaque, insensitive, slow lender and they wanted him to explain why all their past loan and credit card applications had been declined. The barrage of questions targeted at Ankit reached a point where Kumanan even wanted Ankit to explain why his voter ID had the wrong address! Ankit smiled and surprised them by saying he shared their frustration of being unable to provide the right loan to the right person at the right time in his old bank and that he also moved to a new age digital company with the intent to redefine lending in India.

Ankit then asked Kumanan and Murthy to explain how they went about getting a loan and got the answer he expected. Like most business owners, they did not have the time to deal with multiple banks and they used an agent to help them get loans. While they did not particularly like their agents, they did send a guy over to their office to fill forms, collect documents, organize bank discussions and get them their funding without them having to figure out every bank, product and process. In addition, Murthy and Kumanan both had multiple suppliers who they had worked out individual credit terms with. They also admitted that whenever they needed urgent money or large sums that banks would not provide, they got it from local moneylenders at exorbitant terms. It was quite beyond them as to why a bank would think they cannot repay a larger loan when they were clearly taking multiple loans and successfully paying them off.

Ankit explained that traditional banks and lenders had very limited scope for loan officers to think out of the box and act beyond established policies.  Banks did not have significantly different products or processes and ended up providing 2-3 year lump sum loans that were not large enough for Kumanan or Murthy.  They always ended up spending time allocating money across various activities such as expansion, payroll, supplier payments, seasonal demands, online vs offline sales where payment cycles were vastly different. The advantage of Ankit’s new age company was three fold: custom products designed to address specific financial needs of businesses, high speed customer experience with minimal documentation, and low pricing due to product features that enable non-conservative underwriting. Kumanan and Murthy’s curiosity was piqued and they wanted to know more.

Ankit asked Kumanan to imagine a world in which he downloaded a mobile app, added all his suppliers and had a line of credit with standard terms available that he could use to pay any supplier any time. He could pick his repayment period and the payment goes through immediately! No need to haggle with each supplier and the credit line grew with usage and regularity of payments. Since he sold online, he also had the option of picking a tailor made e-commerce loan where repayments were mapped to the payment cycle and a transparent cash flow control mechanism ensured that many more people qualified for affordable large loans. These loans even adjusted themselves for seasonality of his business and he could request top-ups as and when he needed them. Kumanan was very impressed that these products were not restricted to his imagination but were actual products that Ankit was able to provide via his new age digital lending company.

Murthy wanted to know if there was something for folks like him who did not sell online. Ankit told him that instead of taking long term loans that may not be utilized all the time but keep accruing interest, Murthy should opt for an invoice financing loan wherein all his supplies to the large software company could be funded as and when they make a purchase from him. That way, he does not have to plan for their expansion and is confident of the right amount of money at the right time and the right rate. Murthy agreed that while this product did sound interesting, he preferred if somebody came to his office to explain the product and handle the paperwork. Ankit mentioned that his company did not have any “paperwork” since most customer information was collected digitally but he is happy to send over a person to Murthy’s office to help guide him through the product and process. Murthy then wanted to know why he could not get a larger loan and Ankit explained that lenders and banks are happy to lend when they have some visibility into the cash flow of a business. As an example, Ankit’s company had recently launched a merchant cash advance product that collected daily payments directly from the credit card machines that Murthy had in all his stores. Typically, it was a lot easier to qualify for such a loan, there was minimal documentation and there was no need to think about payment due dates!

Having given up hope of ever hitting the gym, Kumanan and Murthy were happy with their new year resolution of trying out custom financial products from new age digital companies and keeping in mind that old may not always be gold!

Tushar Garimalla

Tushar has deep expertise in credit, risk management, portfolio management and analytics gained during his 10-year career with HSBC and Capital One in India and the US. Most recently, he worked on a small business credit card portfolio purchase for Capital One including business development valuations, due diligence, system integration and credit policy development. Tushar graduated from IIT Madras with a B.Tech in Electrical Engineering.

Tushar heads Decision Sciences at Capital Float. 

Oct 24, 2018