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3 Terms You Must Understand Before Applying for a Small Business Loan

Small business loans are a popular way of funding business expansions. The growing popularity has led to an expansion in the number of loan products that finance companies have to offer to suit various needs. Typically, in the case of MSMEs, lenders prefer to sanction secured business loans. This is because of perceptions about track record, repayment ability, and credit-worthiness that may not always be completely accurate. Nonetheless, secured loans remain the most viable choice for small businesses in need of a company loan.

Secured loans are backed by some physical security provided by the borrower known as collateral. This collateral could be in the form of Fixed Assets (Plant & Machinery, Equipment, Vehicles, Fixtures, and similar items), Land & Building, or sometimes even Cash/Bank deposits. There are 3 terms relating to secured loans and collateral that need to be understood well before you consider choosing which loan to go for:

Pledge:

In a Pledge, the borrower gives the actual physical and legal possession (but not the ownership) of the asset to the lender. The assets are retained by the lender till the borrower repays the entire loan. In case of any default, the lender is free to dispose of the asset and use the proceeds to settle the dues (principal + interest due). Typical assets used for pledging are Bullion, Jewellery, Inventory, and Financial Securities.

Hypothecation:

Hypothecation is a charge against movable assets with possession of the asset remaining with the borrower. The hypothecation charge is removed when the loan is settled in full. In case of default, the lender has to first take possession of the asset and then dispose it to recover the dues. Car loans are the most popular product in which hypothecation is used. The registration certificates would state that the vehicle is hypothecated to the lender and because of this, the borrower cannot dispose of the vehicle without the lender’s written consent.

Mortgage:

A Mortgage is used for creating a charge against immovable property which typically includes land or buildings. The possession remains with the borrower and he/she is free to use the property for any purpose. Even in this case, the borrower is not free to dispose of the asset with the lender’s written consent until the loan is settled in full. The most widely known use of Mortgage is in Home Loans.

Now that each term is defined, let us look at some of the clear differences between the three terms. This is important because most borrowers seem to use the terms interchangeably.

  Pledge Hypothecation Mortgage
Type of asset Movable Movable Immovable
Possession of asset Lender Borrower Borrower
Cost of loan Relatively higher Moderate-Low Low
Loan to Value ratio Comparatively lower Medium High
Tenure Short (1-2 yrs) Mid (1-5 yrs) Long (up to 20 yrs)
Margin calls Possible Unlikely None
Lender’s liquidation risk Low Moderate High
Examples Gold loans, Advance against FDs, Inventory Loans Vehicle Loans, Receivables Loans, Working Capital advances Home Loans, Loan Against Property

The author works with LoanFrame – an SME finance company.

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