The Difference Between Secured and Unsecured Business Loans
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 numerous others), you might not be able to receive a loan unless it’s secured.
Before applying, we suggest determining whether you’ll need to pursue a secured or unsecured loan. In this post, we’ll help you decide which option is the best option for your company right now.
What is the Difference Between Secured Business Loans and Unsecured Business Loans?
Secured business loans are the most common and straight-forward kind of lending because they are backed by an asset, such as equipment or real estate. If the borrower defaults, the 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 want lower interest rates and the ability to pay back the investment over longer periods of time.
Pros of Secured Loans
Typically, banks are willing to work with 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, up to 30 years. Also, since secured loans represent less risk for the lender, there may be some leeway if you accidentally miss a payment or submit it after the deadline.
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 lender legal permission to seize the asset if you can’t make payments according to schedule 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. If losing this collateral could cause major financial damages to your livelihood, you should reconsider this financing option.
For business owners with strong personal credit, unsecured business loans, which aren’t backed by collateral, may be a viable option. However, this type of financing represents more risk to the lender. If the borrower defaults, 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 – such as 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 who’ll come after you. 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.
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.
Cons of Unsecured Loans
This financing option is typically more expensive and often comes with short repayment periods. It’s also much harder to qualify. Lenders will want to know that your business has been around for several years, produces strong revenues or positive cash flow, and that you as the owner has excellent personal credit history. Defaulting on unsecured business loans can mean financial ruin and damaged credit for you and your business, so make sure you’re confident in your business prior to applying.
Conclusion: Secured vs. Unsecured Loan
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 therefore offer more attractive terms for partially-secured loans than unsecured, such as lower interest rates and longer repayment time.
Editor’s Note: This post was updated for accuracy and comprehensiveness in October 2018.
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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.