Secured vs. Unsecured Business Loans: What You Should Know
As with any form of financing, debt structure and payment schedule will depend on the bank, your credit history, and your relationship with the lender. Due to these factors, as well as many others, you might not be able to receive a loan amount unless it’s secured.
Before applying for business funding, we suggest determining whether you’ll need to pursue a secured or unsecured loan. In this post, we’ll help you decide which financing option is the right fit for your company.
Secured vs. Unsecured Loans: How Are They Different?
Secured Loan Definition:
If the borrower defaults, the business lender assumes ownership of the property and may try to recoup their loss by selling it. Below, you’ll find the types of collateral that could be used to secure a loan:
- Personal Cash
- Unpaid Invoices
- Real Estate
As a business owner, you may benefit from this option if you want to limit your personal risk in the investment. Or, maybe you want lower interest rates and the ability to pay back the investment over a longer period.
To further explain the intricacies of secured loans we’ll review the pros and cons of this loan option below.
The Pros of Secured Loans:
Typically, banks are willing to work with small businesses when their investment is somewhat assured.
For large purchases that you don’t expect to pay off quickly (such as real estate), secured loans may allow you to pay them back over time. In fact, these loan terms can go up to 30 years. Also, since secured loans represent less risk for the lender, there may be some leeway if you accidentally miss a weekly or monthly payment or submit it after the deadline.
The Cons of Secured Loans:
Secured loans are limited by the fair value of the asset pledged as collateral. Taking out a secured loan means you’re giving the small business lender legal permission to seize the asset if you can’t make the agreed upon payments on-time.
It’s important to note that the lender can seize the asset without a court order. Due to this, it could put the future of your business in jeopardy, in addition to your personal finances.
Therefore, you should be careful when putting up collateral to secure any amount of money. If losing this collateral could cause major financial damages to your livelihood (such as necessary equipment), you should reconsider this working capital option.
Unsecured Loan Definition:
The term ‘unsecured loan’ means that the borrower doesn’t have to provide collateral in order to qualify and receive their financing.
For business owners with a strong personal credit score, unsecured business loans may be a viable option. However, this type of business financing represents more risk to the lender. If you borrow money and default on your payments, there is no asset to seize.
For this reason, unsecured loans typically come with stringent qualification standards (such as credit score requirements) and higher interest rates. In addition, banks may require a different security feature as an alternative to collateral – like a percentage of your credit card transactions.
If you default on an unsecured loan, the bank may pursue legal action against you, employ a collection agency, or sell your outstanding debt to a third-party.
Some unsecured loans require a personal guarantee, which means the lender will be able to appropriate your assets if your business defaults on the loan. This option is best for entrepreneurs who need large amounts of cash quickly and expect to pay it off in a short time.
The Pros of Unsecured Loans:
Unlike secured financing, unsecured business loans aren’t bound by the value of the underlying asset. Not having collateral can bypasses lengthy appraisal processes, which means you could get the cash you need sooner. In the event your business files for bankruptcy, unsecured loans have the potential to be forgiven.
The Cons of Unsecured Loans:
This business financing option is typically more expensive and often comes with short repayment periods. Because of these reasons, it’s also much harder to qualify for.
When you apply for a secured loan, lenders will want to know that your time in business has been several years, produces strong revenues or positive cash flow, and that you have excellent personal credit history. To ensure you meet their credit requirement, we suggest running your credit report prior to applying for unsecured business financing.
Defaulting on unsecured business loans can mean financial ruin and damaged credit, so make sure you’re confident in your business prior to applying.
Conclusion: Understand the Differences Between Secured and Unsecured Loans
For new businesses or entrepreneurs who are just starting out, secured business loans may be the only available option. In comparison, for established business owners who are willing to pay higher interest rates, unsecured credit can offer more flexibility, larger amounts and faster access to cash. However, they may be held personally accountable if the business defaults.
Entrepreneurs may also want to consider partially secured loans, where collateral is required but doesn’t have to cover the principle. Lenders assume less risk with these types of loans because they typically aren’t discharged by bankruptcy, and the pledged asset guarantees some return in the event of default. Banks may offer more attractive terms for partially secured loans than unsecured, such as lower interest rates and longer repayment time.
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Editor’s Note: This post was updated for accuracy and comprehensiveness in June 2021.
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.