As a business owner, you might already be aware of the concept of security when applying for a business loan. The financial institution where you submit your loan application asks you to provide a guarantee of repayment. This guarantee is called security.
Did you know there are two types of loan security, primary security and collateral security, and these terms are not interchangeable? Understanding loan security and its types will help you organise your resources better when taking a business loan. Let’s take a deep dive into the world of loan security and its two types, primary security and collateral security, to understand their importance and critical differences.
What is Security?
When you take out a loan from a financial institution, you provide a tangible asset as security. This tangible asset (e.g., a house or a car) ensures that the lender is financially covered if you are unable to repay the loan. Security then secures the lender’s financial interests and incentivises you to repay the loan on time.
The loans which require security are called secured loans. Examples of secured loans include home loans, vehicle loans, etc. Unsecured loans, like some types of personal loans, do not require any security. You can typically avail of secured loans at much lower interest rates compared to loans that are unsecured. This is because, with security, the lender is assured of getting their money back in case of adverse circumstances.
Security serves two purposes in a loan. First, it ensures that the lender’s rights are safeguarded in case of a loan default or other adverse conditions. Second, it also acts as a deterrent for the borrower against loan default.
What is Primary Security?
Primary security is your asset, which is directly associated with the loan. If you are unable to pay back the loan, this asset will be first considered by the lender to recover their money. Some common examples of primary security are the assets for which you take the loan, like a car for a car loan or a house for a home loan, etc. Some characteristics of primary security are as follows:
1. Direct relation to loan:
Primary security is the asset or project for which you take the loan. Hence, primary security is directly tied to the loan in this respect.
2. Source of repayment:
If you default, the assets you pledge as primary security are the primary source of loan repayment.
3. Specific form:
Usually, the assets you put up as primary security will be agreed upon by you and the lender when signing the loan agreement.
4. Tangible protection against default:
Primary security is a tangible asset for protection against loan default.
What is Collateral Security?
Now, let’s talk about collateral security. Collateral security, as the name suggests, is additional protection that you offer to the lender if the primary security is insufficient to cover the entire loan amount. Collateral security can take various forms and is not directly tied to the loan. Let’s understand this with the help of an example.
Suppose you own a process line and want to add a new machine to your production plant. You approach the lender for a loan. In this case, the machine will become the primary security. If the lender demands additional security, say you put up your company stocks, which become collateral security. Some characteristics of collateral security include:
1. Supplementary protection:
In case of loan default, the financial institution will try to recover their money first by using the primary security. Collateral security comes into the picture only when the primary security turns out to be insufficient.
2. Diverse forms:
Collateral security can take many forms, like property, stock options, bonds, vehicles, jewellery, etc.
3. Increased chance of approval:
By providing collateral security, you can increase your chances of loan approval as it provides additional risk mitigation for the lender. To elaborate further, collateral security is like a buffer for the lender. The larger the buffer, the higher the lender’s risk mitigation and the higher the chance of loan approval.
4. Loan and risk specific:
For a particular loan, the collateral security will be decided by the type of loan and your perceived ability to repay it by the lender. Additionally, some types of loans, like micro-credit or instant loans, do not require any collateral.
Differences between Primary Security and Collateral Security
1. Priority of repayment
In case of loan default, the priority is given to the primary security to recover the loan amount. If the primary security is insufficient to recover the entire amount, the lender considers collateral security for loan satisfaction.
2. Relationship to the loan
Next on the list of primary security vs. collateral security is the relationship to the loan. Primary security is the financial asset directly linked to the loan. Collateral security is indirectly linked to the loan and provides additional assurance.
3. Liquidation at the time of default
Primary security and collateral security differ in liquidation at the time of loan default. As soon as a loan defaults, the primary asset is immediately sold off or liquified to recover the loan amount. If the entire loan amount is not recovered, the lender then liquefies the collateral security.
4. Legal implication and creditor’s rights
If the borrower declares bankruptcy or defaults on a loan, the primary security is given legal precedence to safeguard the creditors’ rights. Compared to this, collateral security is a lower priority for ensuring creditor’s rights in case of default situations.
Concluding thoughts
We hope that now you completely understand primary security and collateral security and their differences. Both primary and collateral security increase risk mitigation for lenders and act as effective deterrents against default.
If you’re a business owner looking for a business loan to expand your business, you might be hesitant to put your personal or professional assets on the line. Keep your assets safe, and consider Tata Capital’s collateral-free business loans.
Tata Capital offers business loans for women with low processing charges and multiple EMI options. So, choose Tata Capital for a business loan, apply and grow your business without worrying about your assets.
11 October 2024
6 mins read
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