LAP- A simple loan product but a risky proposition for SMEs in India
LAP has been positioned as a simple loan product among SMEs in India. However, it can endanger the sustainability of business if not applied properly.
Among a host of loan products provided by banks, a relatively popular product is the Loan against property (LAP) or mortgage. The product clicks with borrowers because it generally allows them to borrow a relatively large sum of money for any need. It has easy documentation, speedy approvals and flexible repayment options.
On the other hand, lower operating cost, larger ticket size and higher profitability attract the lenders.
Many SMEs in India consider LAP as an alternative to overcome challenges associated with other loan products which come with many conditions and rigid oversight on end use.
Whether LAP is a panacea for loan funding issues?-Not so, Experience says:
Recently I came across a case of LAP extended to meet the working capital needs of a firm having poor cash flow but good collateral. He is in servicing industry and has been stressed due to the economic downturn and industry-specific challenges. Since there was a good collateral security, the lender has been generously extending top-ups periodically to keep the unit afloat and loan remains healthy. However, the loan amount reached the peak level (against the value of the security) and the turnaround was not in sight. Later recovery proceedings were initiated by the lender. At the closer scrutiny, one can find that the lender has been funding firm’s losses and there is hardly any change in the performance matrix all along.
In another case, LAP against the residential property had been extended to bring in equity for expansion of the business. Business could not begin commercial operation on time due to some issues and the signs of distress started appearing. The impact was devastating as his personal assets which were created over the years had just been subsumed into expanding the business. What stands out, in this case, is excessive leverage spreading into personal space.
Where lies the fault- Lender or Borrowers?
There is a widespread practice among many banks and NBFCs to ignore the cash flow analysis and assessment of the suitability of product in their drive to increase the market reach and profitability. On the other hand ease of availability of loan without much scrutiny prompting many SMEs to borrow under this window and spend without much observance of discipline. Many rating agencies are warning that default level under LAP is on the rise.
Please read Financial Planning for SMEs
How to avoid LAPs
- Choose suitability over simplicity: Each loan product has its own characteristics which make it suitable for certain needs of SMEs. Choose a loan product which is having a term of repayment aligned with cash flow characteristics of your business.
- Aware of growth needs of your firm: If a company is in the growth stage, its working capital requirement will keep growing. In such circumstances, it is not desirable to avail mortgage loan or even OD against collaterals security as it will limit the borrowing level irrespective of need of business
Cash credit limit with the security of current assets and collateral of fixed assets is best suited. Because this will keep the opportunity to increase the borrowing limit as banks will look at working capital requirement based on assessment of MPBF.
- Avoid the temptation to spend for unproductive purposes: Mortgages normally come without any restrictions on end use which is normally not the case with other loan products. As a consequence, it is not uncommon to find entrepreneurs splurging the proceeds from such loans on unproductive items and investing in speculative activities or real estate. Such diversion may hurt the business if there is no increase in free cash flow to service the mortgage.
- Avoid the allure of lower interest cost: One argument entrepreneurs put across in favour of mortgage is lower & fixed interest rate where as the investment elsewhere would yield much more.
However many entrepreneurs expressed that such investment did not come handy in need of time and distress became aggravated. Secondly when in distress, the value of the property declines steeply, however, debt level remains fixed.
- Avoid mortgage during start-ups: Start ups are risky and entrepreneurs should avoid pledging the house property to raise funds for the business at least till it stabilises.
Please read Why SMEs need professional Financial Advisor
Caveat: LAP is not meant to called bad……
In certain circumstances LAP can come to your rescue. Few of them are:
- Debt consolidation– You may have borrowed from various sources at high rates and if you may be keen to consolidate all the debts with a mortgage.
- Gradual reduction of debt– If you are looking forward to reducing the debt gradually you may opt for a mortgage.
- Poor credit rating: Sometimes credit rating may have suffered and bankers are not keen to increase the limit, in such circumstances mortgage may help.
Simplicity of mortgage product should not be the sole criterion for raising a loan. One should not lose the sight on suitability, end use, growth needs, etc.
Get a financial plan devised by professional financial advisors and ensure that the loan products meet the need of business without risking the sustainability.