The Pros and Cons of an Unsecured Line of Credit
A line of credit is a lending arrangement between a financial institution and a business or individual. It’s considered unsecured when the borrower isn’t required to put up assets as collateral. Lenders compensate for the additional risk associated with unsecured loans by limiting the funds you can borrow and charging higher interest rates.
While unsecured lines of credit have many advantages, they also have their limitations. Consider the pros and cons when determining if an unsecured line of credit is the best option to meet your cash flow needs.
Pro: No Collateral
Since you don’t need to submit collateral for an unsecured line of credit, your business or personal assets can’t be seized if you default on your payments. Still, you’ll need to adhere to the lender’s terms and make your payments on time to maintain good standing. If you fail to do so, the lender will likely send debt collectors to secure repayment, and defaulting on payments will negatively impact your credit score.
Con: Smaller Loans
Lenders profit on loans by charging interest, but they lose money if you don’t pay them back. To offset the higher risk of default with unsecured lines of credit, lenders typically limit the amount of money you can borrow. Your credit limit is based on your credit history and characteristics of your business – if either is deemed risky, the amount of credit you’re given may be small.
Pro: Open-Ended Financing
Traditional bank loans typically disburse funds for a specific purpose and require you to pay them back in regular installments. However, a line of credit is available for you to borrow from only when you need it, and you can use borrowed funds for any reason. Although you don’t have a set repayment schedule with a line of credit, you’ll need to make minimum monthly payments if you carry a credit balance. You’ll also be charged interest on any funds you borrow that aren’t repaid immediately.
Con: High Interest Rates
For the same reason lenders limit the amount you can borrow, they also charge higher interest rates on unsecured loans. According to Debt.org, the average rate on an unsecured line of credit in 2015 ranged from 9 to 15 percent, and these rates can be much higher if you have weak credit. Ultimately, higher interest rates mean higher monthly payments if you tend to carry a balance.
Pro: Quick Processing Time
While the application process for a traditional bank loan can take weeks or months if you’re a small business owner, the processing time for a business line of credit is typically much faster, especially if you consider alternative lenders. If you have a strong credit history and credit score, you could be approved for a line of credit in at little as 24 hours.
Con: Easy to Overspend
Because funds are available to you on demand with flexible repayment terms, you may be tempted to overspend or abuse your line of credit. Also, if you aren’t disciplined with credit cards, you may quickly find yourself in over your head with a line of credit.
When it comes to financing your business, there’s no one-size-fits-all solution, and unsecured lines of credit aren’t right for everyone. Before deciding, weigh your financing options along with your business needs and spending habits. Then, pick the solution that best aligns with your circumstances and goals.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.