Many companies have found that business loans can be extremely helpful in managing cash flow, purchasing new equipment or expanding their operations. This is especially true for start-up businesses and small businesses that have a limited amount of available funds and capital.
However, the company typically has to provide collateral as insurance against the loan to get a business loan. But why do lenders require a deposit to get a loan?
Here are the reasons why business loans need deposits:
1. To Put Up Collateral
Collateral is a form of protection for the lender if the borrower loses the ability to repay the loan. The only exception to this rule is the so-called "unsecured loan", which doesn't require collateral.
Most business loans are secured by collateral - a property, a building, inventory, machinery and equipment, or another valuable item. Even if a high degree of risk is involved, banks will still require the borrower to pledge collateral to support the loan.
Some loans have higher interest rates because they have an increased risk of not being paid back or consist of a higher risk loan type.
2. To Determine the Creditworthiness of the Borrower
Deposits are also an excellent tool for lenders to evaluate applicants' creditworthiness. It is a way to determine the applicant's intent and willingness to repay the loan. This is also an effective tool to prevent people with poor credit histories from abusing or misusing credit.
When a borrower deposits money in the form of collateral, their creditworthiness is improved. This shows the lender that the borrower has a financial asset that is "offered as security." This implies that the borrower is not in a bad financial position and is financially stable.
3. To Determine the Accessibility of the Credit Market
Deposits can also help financial institutions and lenders determine the accessibility of the credit market. A borrower with a long history of borrowing from financial institutions and paying back the money on schedule is held in high esteem by lenders.
It increases their reputation, which can positively impact their future business activities. For example, a merchant with timely payments may be upgraded to a higher merchant credit card status. Or a borrower who has good credit may be qualified for a larger loan than a borrower who has no credit history.
Therefore, it's more likely that they can access the credit market to obtain business loans in the future and at a low-interest rate.
4. To Protect Lenders from Potential Risk
Financial institutions are not a charity, and they do not lend money for free. Business loans that involve high risks require collateral. And the requirement for collateral increases the likelihood of repayment. This protects lenders from the risk that comes from loaning money.
In a default, the lender has the right to claim the business loan's collateral to recoup their losses. In this way, lenders can minimise the risk of debt.
Conclusion
As you can see, there are several reasons why deposits are required for most loans. Deposits are nothing more than a tool to protect lenders.
It can help them evaluate the borrower's financial strength and determine their creditworthiness. Deposits can also help lenders to assess the accessibility of the credit market to their customers. In other words, deposits don’t count as "free lunch" for borrowers.
However, if the borrower can effectively protect the loan and pay it back on schedule, they can get a reasonable interest rate from any lender.
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