The Pros and Cons of an Unsecured Line of Credit
For example, an unsecured line of credit is a flexible solution that allows you to access capital when needed and pay it back as you can, assuming you meet the lender’s terms. 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. In this post, we’ll explore the pros and cons of an unsecured line of credit, so that you can determine if this is the best way to meet your cash flow needs.
Should Your Business Pursue an Unsecured Line of Credit?
Pro: No Collateral Required
Unlike a secured line of credit, collateral isn’t required for this type of financing. Therefore, 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 Loan Amounts
As you probably know, 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. In addition, you’ll 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. They can also vary, depending on the prime rate. 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. This is especially true if you apply for financing from 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: It’s 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.
Other Business Financing Options:
Although an unsecured line of credit is beneficial to many business owners, it’s important to weigh all your options. Here are some other financing products that you should also consider:
- Merchant Cash Advances: Does your business accept a high volume of credit card transactions? If so, a cash advance could be a viable option. You’ll receive a lump sum, and in exchange, you’ll remit a percentage of your future credit card sales to fulfill your obligation.
- Revolving Line of Credit: With revolving credit, you’ll receive a maximum credit line that you can borrow against. Then, you can either repay the amount you’ve used all at once, or in regular payments. This amount will never go away; as long as your account remains open, you can borrow up to the designated amount, and once you pay it back, you can borrow up to that amount again.
- Non-Revolving Line of Credit: Unlike revolving credit, once you spend the amount you were approved for, it’s gone. Even once you repay it, the line will no longer exist, so you’ll need to apply for another line.
- Secured Line of Credit: For businesses with poor credit, a secured line of credit can be a great option. You’ll submit collateral to secure the line of credit, which makes it easier to qualify (even if you have a low credit score).
- Bridge Financing: If your business gets paid in installments, bridge financing might be worth pursuing. When you’re in-between customer payments, you can use this type of financing to bridge the gap.
- Equipment Loan: Does your business need equipment to produce your products or services? If so, an equipment loan will enable you to afford the tools that you need.
- Inventory Financing: Most businesses require some form of inventory to sell or use for operational purposes. If you need financing specifically for inventory, you should consider pursuing this option.
Conclusion: Consider Unsecured Credit Lines
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.
Has your business utilized an unsecured line of credit? Tell us about your experience in the comment section below!
Editor’s Note: This post was updated for accuracy and comprehensiveness in August 2019.
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.