Primary Security vs Collateral Security: Know the key differences between them in Business Loans

Introduction

When it comes to business loans, primary security and collateral security are two distinctive types of asset backing used for the loan. Understanding primary security vs collateral security can help you make better borrowing decisions. It also helps you know what a lender may ask for before approving a loan.

When you apply for a business loan, a lender may ask you to provide security. This gives the lender confidence that the loan will be repaid. Depending on the type of loan and the lender's policy, you may need to provide only primary security or both primary and collateral security. Some loans, such as a business loan without collateral, may not require any security at all if you meet the lender's eligibility criteria.

In this blog, types of loan collateral are explained in simple words. It also covers the difference between primary and collateral security, why they matter, and when they are required.

What is Security?

In banking, security is an asset that a borrower offers to a lender while taking a loan. It gives the lender a legal right over the asset if the borrower fails to repay the loan as agreed.

The borrower is expected to repay the loan through regular EMIs or instalments. Security is used only if the borrower defaults, subject to the loan agreement and applicable laws.

The type of security required depends on factors such as:

• Type of loan
• Loan amount
• Nature of the asset being financed
• Borrower's financial profile
• Lender's internal lending policy

Some loans require only primary security. Others may require both primary and collateral security. In some cases, eligible borrowers may also get a business loan without collateral.

Understanding the primary security vs collateral security meaning helps borrowers know why lenders ask for different types of security during the loan process.

Also Read: What is Unsecured Business Loan?

Key Differences between Primary and Collateral Security

Understanding the Key Differences

A. Priority of repayment:

• Primary Security: Given precedence in repayment over collateral security, ensuring immediate satisfaction in case of default.
• Collateral Security: Repaid after primary security in default scenarios, with secondary priority in repayment.

B. Relationship to the loan or obligation:

• Primary Security: Directly tied to the loan or obligation, serving as the main asset linked to the financing.
• Collateral Security: Indirectly linked to the loan or obligation, providing additional assurance beyond the primary security.

C. Liquidation process in default scenarios:

• Primary Security: Immediately liquidated in case of default, facilitating prompt repayment to the lender.
• Collateral Security: Liquidated after primary security, ensuring repayment but with secondary consideration in the event of default.

D. Legal implications and rights of creditors:

• Primary Security: Holds higher legal priority in bankruptcy or default situations, ensuring creditors' rights are safeguarded with precedence.
• Collateral Security: Possesses lower legal priority compared to primary security, offering creditors secondary rights and remedies in case of default.

Types of Security

Security used in loans is generally divided into two categories:

• Primary Security
• Collateral Security

Both help reduce the lender's lending risk. However, they serve different purposes.

Understanding these types of loan collateral helps borrowers know what documents and assets may be required before applying for a loan.

What is Primary Security?

Primary security refers to the specific assets directly associated with a loan transaction and pledged by the borrower to secure the financing the lender provides. These assets serve as the primary source of repayment in the event of default, offering a guarantee to the lender against the risk of non-repayment.

Examples of Primary Security:

• A house purchased through a home loan.
• Machinery purchased through a business loan.
• A commercial vehicle bought using a vehicle loan.
• Equipment financed for business expansion.

Characteristics of primary security:

• Direct relationship with the loan: Primary security assets are closely tied to the loan they are pledged, representing the financed item or project.
• Source of repayment: These assets act as the primary source of repayment for the lender in case of borrower default.
• Specificity: Primary security assets are identified and agreed upon between the borrower and lender at the time of loan agreement.
• Protection against default: By pledging primary security, borrowers provide a tangible guarantee to lenders, reducing the risk of default and ensuring the safety of the loan transaction.

Also Read: Impact of GST on Wholesalers and Retailers

What is Collateral Security?

Collateral security refers to supplementary assets the borrower provides to the lender, in addition to the primary security, to secure a loan. It is a secondary form of security, utilised when the primary security is insufficient to cover the entire loan amount in the event of borrower default.

Understanding the types of loan collateral helps borrowers know why some loans require additional assets while others do not.

Examples of Collateral Security:

Depending on the lender's policy, collateral security may include:

• Residential property
• Commercial property
• Fixed deposits
• Government-backed securities
• Other eligible financial assets accepted by the lender
  
  

Characteristics of collateral security:

• Supplementary protection: Collateral finance security acts as an additional layer of protection for the lender, providing further assurance against the risk of default by the borrower.
• Secondary in nature: Collateral security is utilised when the primary security is insufficient to cover the loan amount, making it a secondary form of security in loan transactions.
• Diverse forms: Collateral lending security can take various forms, including immovable assets like real estate (land, buildings), financial assets (stocks, bonds), or personal assets (vehicles, jewellery).
• Risk mitigation: By providing collateral security, borrowers mitigate the lender's risk, enhancing the likelihood of loan approval and favourable terms.

Loan-specific: The requirement for collateral security may vary depending on the type of loan and the perceived risk associated with the borrower's ability to repay. While some loans may require collateral, others, such as micro-credit or instant loans, maybe collateral-free.

When Do Banks Ask for Collateral Security?

Banks do not ask for collateral in every case. The requirement depends on the overall risk of the loan.

A lender may ask for collateral security when:

• The loan amount is high.
• The financed asset does not provide enough security.
• The borrower's financial profile needs additional support.
• The lender's credit policy requires extra security.
• The loan involves higher lending risk.

For example, a borrower applying for a secured business loan against property may offer a residential or commercial property as collateral, depending on the lender's eligibility criteria.

How Do Banks Decide Which Security to Accept?

Banks carefully assess the asset before accepting it as security.

They may check:

• Ownership of the asset
• Market value
• Current condition of the asset
• Legal documents
• Existing loans or charges on the asset
• Ease of selling the asset, if required
• Overall repayment capacity of the borrower

After reviewing these factors, the lender decides whether the asset can be categorised as primary or collateral security.

Can You Get a Business Loan Without Collateral?

Yes. Some lenders offer a business loan without collateral to eligible businesses.

Instead of asking for property or other assets, lenders may assess factors such as:

• Business turnover
• Repayment capacity
• Credit history
• Business vintage
• Banking relationship
• Internal credit assessment

Things to Remember Before Offering Security for a Loan

Before pledging any asset, keep these points in mind:

• Read the loan agreement carefully.
• Understand which asset is being offered as security.
• Check whether additional collateral is required.
• Ensure that all ownership documents are complete.
• Know your repayment schedule.
• Ask how and when the security will be released after the loan is fully repaid.
• Clarify all charges and terms before signing the agreement.

Examples of Primary Security and Collateral Security

1. Example of Primary Security:

Let's say you take out a business loan of ₹40 Lakh to purchase new manufacturing equipment for your factory. The lender requires you to pledge the equipment as the primary security against the loan. In this scenario, the machinery being financed serves as the primary security for the loan.

2. Example of Collateral Security:

Suppose you need funding to expand your business operations and seek a loan of ₹1 Crore from a financial institution. While the new office building you plan to purchase is the primary security for the loan, the lender also requires additional assurance. As collateral security, you pledge your existing property, to secure the loan. In this case, the office building represents the primary security, while the existing property acts as collateral security.

Why Collateral Security Is Needed?

Collateral security is essential in specific loan scenarios to bolster lender confidence and mitigate the risk of default. A lender may ask for collateral security when:

• The loan amount is high.
• The lender needs additional security.
• The borrower's financial profile requires further risk assessment.
• The lender's internal policy requires extra security.
• The financed asset alone may not provide sufficient comfort for the lender.

For some businesses, offering a property may help them qualify for a secured business loan against property, depending on the lender's eligibility criteria and loan policy.

What Are Collateral-Free Loans?

Collateral-free loans, supported by entities like CGTMSE, offer lending without collateral requirements, aiding enterprise growth. They enhance accessibility for micro and small businesses, simplify loan processing, and promote entrepreneurship. While posing higher risks for lenders, credit guarantee schemes mitigate these risks. The policy resolves funding challenges and encourages economic development.

Grow Your Business with Kotak Mahindra Bank

Looking for funds to expand your business, manage working capital or meet operational expenses? Kotak Mahindra Bank offers collateral-free business loans of up to ₹1 Crore to MSMEs looking to expand or manage their operations. Check the eligibility on the Kotak website and apply now!

Conclusion

Understanding the primary security vs collateral security meaning can help you make informed borrowing decisions. It also helps you understand why lenders ask for different types of security for different loans.

Knowing the types of loan collateral explained makes it easier to prepare the right documents before applying. Depending on your eligibility, you may qualify for a business loan without collateral or choose a secured business loan against property if additional security is required.

Before applying for any business loan, always review the lender's eligibility criteria, repayment terms and security requirements carefully. Choosing the right loan option can help your business meet its financial needs with greater confidence.

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