A series of loan defaults and late payments have made Indian banks extremely cautious about lending to small businesses. Banks either lend them at very high interest rates, or refuse to lend them altogether. If you are a small business owner, collateralization is one way in which you can improve your credibility in the eyes of banks, and reduce your cost of funds (interest rate paid).

Collateralization happens when a borrower pledges an asset (such as land, shares, and tangible business assets) with the bank, as security, to cover the bank’s losses in case the borrower defaults. Here’s how collateralization matters to a small business like yours:

Better lending ability: Raising enough money to fund growth is one of the biggest challenges that small businesses face. This is because small businesses have little proven credibility, un-established business models, and low future cash flow certainty. This makes lending to small businesses a risky affair for banks and other lenders.

By pledging an asset with the bank, you are assuring the bank that it will not make a total loss on its credit, even if you default. The bank can conveniently sell the pledged asset and recover its money, in case you default. The insurance offered by the collateral will increase the bank’s faith in you, and make it willing to lend you more it normally would. Higher the value of the collateral, the more confident will the bank feel about lending you.

Low interest rate: A bank demands high interest from borrowers that it is not comfortable with lending to. This way, the bank can receive a large part of its loan amount in the initial years of the loan, and insure itself against a default in later years. For example, if a bank has lent you Rs 100, at an annual interest of 18%, for 10 years; your EMI would be higher than if it were to lend you the same amount at, say, 12%.

A high EMI will ensure that the bank at least recovers the Rs 100 it lent you, in the initial years, and safeguards itself from a default in later years. Banks usually lend to small businesses at a high interest rate because of the uncertainty that surrounds the earnings ability of these businesses. If you can offer your bank collateral of high value, it will have something tangible to hold on to while its loan is gradually paid off. So you can negotiate a favorable interest rate on your loan by pledging a premium asset. Collateralizing can be highly valuable in a high interest rate environment, such as the present.

Working capital flexibility: Raising collateralized working capital loans is very common among small businesses. Small businesses try very hard to create a place for themselves in the market, and they need an abundance of working capital (i.e. short term) resources to do so. The ability to comfortably raise a working capital loan, at a low cost, allows a business to stock a large inventory, offer easy terms of payment to its customers, and smoothly tide over challenging times.

The company doesn’t have to push its customers to pay early, so that it can meet its expenses. Easy availability of working capital credit also obviates the need for a business to maintain large cash reserves. The business can use its limited cash reserves to exploit critical growth opportunities, without worrying what would happen if the investment backfires.