Always prefer a Secured loan compared to an Unsecured loan
Secured loans are loans that require collateral security for borrowers. These loans are covered by some collateral security like building, gold, stock, debtor, plant machinery, etc
Unsecured loans are the type of loans that are not covered by any collateral security. Since unsecured loans are not covered by any collateral security, the risk involved in these loans is high as compared to secured loans. Therefore any financial institute or bank or NBFC is charging high rates of interest on unsecured loans as compared to secured loans.
Now let's discuss why you should opt for a secured loan as compared to an unsecured loan due to the following reasons:
The cash flow of business is adversely affected in unsecured loans in terms of lessor period. Sometimes a borrower finds it extremely challenging to make timely EMI repayments on an unsecured loan, which leads to EMI default. In this condition performance of the borrower and the CIBIL score, both are adversely affected.
Due to a poor CIBIL score and a default EMI payment, it is very difficult for MSME Loan borrowers to get another loan for business expansion, even a secured loan is not available once CIBIL starts to worsen.
In unsecured loans where EMI is high, it adversely affects the cash flow of business, during the high competition in the market where profit is low. It is very difficult for the borrower to repay an unsecured loan with an interest rate of range 18% P.A. to 50% per annum within a tenure of 3yrs.
Most of the time borrowers struggle to arrange the EMI of the loan rather than focussing on the business expansion. Many businesses fail as a result of making the incorrect decision to obtain an unsecured loan without a thorough understanding of the business cash flow.
Let's understand the above fact with an example.
A client was in the business of manufacturing discs for a corporate client. He approaches a financial consultant to get a loan of Rs 6 crore for the purchase of plant machinery. The loan was arranged for the client for an amount of Rs. 6 crores from a govt bank for the purchase of machinery but on the condition that the borrower has to arrange a pollution certificate before disbursement of the loan.
So because the factory was situated in a location where a pollution certificate could not be obtained by the borrower, so it is difficult to get the loan. The borrower approached different banks and NBFC and availed of a loan of Rs 6 crore as an unsecured loan, with an EMI of Rs 21 lakh/month, at an average interest rate of 18% per annum.
The borrower used the entire loan to purchase plants and machinery, and he also has some working capital limits with another bank. The client margin on the product was 5% only and the client’s working capital cycle was 90 days only.
The maximum capacity of these machines was to generate a maximum sale of Rs. 30 crores, with the client's yearly commitment of Rs. 2.32 crore. the client will generate a profit is 1.50 crore only. There is a clear mismatch between the cash inflow and outflow. If the client's factory was operating at its full capacity, there would be a 0.82 crore fund shortage during the year.
After 6 months, the client’s EMI starts to bounce and after 9 months the client was bound to close his business, and sell all machinery, and still a lot of defaults from banks, as the sale of machinery amount is less as compared to bank liability.
Findings of the case
The moral of the above case are: