Business loans are an essential tool for entrepreneurs to manage and grow their businesses. This need is especially acute for small business owners, who do not have as much cash flow and access to capital as larger businesses. This is further complicated by the fact that micro, small and medium enterprises (MSMEs) in India are struggling to find lenders who would give them loans without asking for collateral (s) or collateral.
Business loans as a category are designed to provide business owners with the necessary capital and the loans are structured in the same way as comparable categories such as personal loans. However, the most important factor in issuing and repaying a loan is the interest rate, which is determined based on several factors.
Here are the factors that influence the issuance of business loans and their interest rates.
Macro factors and individual factors
Access to loans and borrowing rates can be determined based on several macroeconomic factors such as:
- Sector and sub-sector of the enterprise (is the sector or sub-sector an economically depressed sector or a seasonal enterprise?)
- Geographic reality (is the company subject to labor shortages, political or environmental instabilities?)
- Infrastructure (does the local infrastructure for roads, electricity and other supply chain needs support the local business?)
The interest rates and the duration of the loans are regulated at the individual level by determining the creditworthiness of the borrower. This is done by taking into account factors such as the payment history of the business owner, the loan amount requested and the purpose of the loan. However, the extent of the impact of these factors on the interest rate varies considerably from one lender to another.
For business loans, factors that play a role in determining the loan term and the interest rate include:
- Profitability and cash flow analysis
- Business owner’s net income
- Type of business and how long it has been in operation
- Other existing loans, even if personal loans
For larger and more established businesses, lenders offer secured loans against the property, which allows for a lower interest rate than typically possible with an unsecured loan for a small or micro business, especially if the owner is the business is a first-time borrower.
The factor that has a strong influence on the probability of approval of a business loan, as well as the interest rate, is the creditworthiness of the borrower. This is based on several considerations, which together are believed to reduce the risk of non-payment or default for the lender. Creditworthiness is primarily determined on the basis of the borrower’s debt-to-income ratio and the borrower’s overall payment history to all of its other obligations, including other expenses and loans.
Traditional lenders require a real estate collateral in exchange for a business loan to secure the issued capital. With a secured business loan, if the borrower does not repay the loan amount, the lender can claim the asset instead of the amount, thereby recovering or partially recovering their debt. As a result, secured loans generally attract a lower rate of interest.
Traditional lending institutions such as banks have held to the rigid frameworks of established credit histories and real estate guarantees to even consider applying for a loan. Many of them still require a considerable amount of documentation, including tax returns and detailed company financial data. As a result, many small business entrepreneurs are repeatedly turned away by banks when they approach them for business loans. Complicated rules and collateral requirements are a deterrent for many new borrowers, who might not have the necessary documents at hand or even be able to handle a long and complicated loan application process without support and guidance in their journey. local language.
Without a formal loan, one cannot establish his credit history and without a real estate collateral one cannot obtain a loan. This catch-22 has left many significantly excluded from access to credit.
Obtaining a loan with a real estate guarantee is an exclusion method, as it prevents many entrepreneurs from accessing the capital they need to develop their business.
Many lenders, especially those focused on financial inclusion, including non-bank financial corporations (NBFCs) and microfinance institutions (MFIs), offer alternatives to MSMEs, many new era lenders are creatively using digital, technology-driven methods of issuing unsecured loans that are not backed by real estate collateral. While this may appear to increase risk on the part of the lender, many organizations today are proving that serving the underserved MSME market can lead to sustainable business growth for entrepreneurs and for the organization itself.
Technology-driven risk assessment
Technology-based risk assessment models help entrepreneurs, especially new borrowers. This is where traditional credit valuation methods are unnecessary. Technology allows lenders to be more flexible and to work with the data points available to them to assess creditworthiness by creating their own scorecard. Fintechs rely on data-driven credit decisions to take out loans, which finally brings many consumers and businesses into the credit fold.
For the new generation of borrowers new to lending, there is a need for alternative risk assessment models that rely on factors other than the availability of a credit bureau report, or even a credit history. filing of goods and services tax (GST) returns. . The extent to which lenders can assess credit risk and grant loans with confidence depends on their established processes and technological sophistication. Using artificial intelligence or machine learning models can facilitate faster response and real-time upgrading of factors that can determine interest rates.
A combination of digitizing technology-based risk assessment processes such as providing KYC videos, electronic disbursements and digital wallet payment options can be used to provide credit in a fast and secure manner.
Data-driven decision making makes the process fast and accurate, and removes human bias from the credit decision, which is especially important when serving the underserved segment of MSMEs.
By improving the efficiency and ease of the risk assessment process, lenders can offer a variety of loan options to a larger group of borrowers.