Once you have established the need for a small business loan, you must then figure out what type of small business loan would work best for you. This doesn’t mean choosing between different business financing products. If you’re comparing a business line of credit to an SBA Loan, you’re skipping too far ahead. The potential borrower must first consider whether it makes more sense to pursue a secured or unsecured business loan. Each option carries various advantages and disadvantages. This decision is especially difficult if you are 100% sure that you can offer collateral that the financial institution will accept.
That’s the primary difference between secured and unsecured business loans. The former option requires collateral, the latter does not. Collateral is an asset the institution can sell to make back most of the money it would lose if you defaulted on the loan. At first, the idea of risking your car or home sounds like a deal-breaker. But when you consider the rewards of secured financing, it’s not so cut and dry as you’d think.
In this article, we’ll explain:
- What are the Requirements for Secured and Unsecured Loans?
- How are Secured and Unsecured Business Loans Different?
- Can You Use Secured Business Loans for Any Purpose?
- Which is Cheaper: Secured or Unsecured Business Loans?
- What are the Risks of Unsecured Business Loans?
What are the Requirements for Secured and Unsecured Loans?
Secured loans cannot be secured by just any expensive asset. The asset’s value must match (or exceed) the amount you intend to borrow. And remember, the value of an asset tends to decrease over time. Thus, you must ascertain the current value of your asset via hard evidence in order for the institution to accept it as collateral.
If you cannot provide sufficient collateral, the decision is over. For this reason, let’s proceed under the assumption that you can meet this requirement.
Other primary requirements for business loans include flawless personal credit, strong cash flow, and substantial capitalization. Depending on the institution, falling slightly short in the credit department may be offset by collateral. You would still be able to access the other advantages of secured business loans, which we’ll explain later on.
If you’re looking for an unsecured business loan, issues in either of these three areas won’t affect your chances of approval. That’s because unsecured business loans were originally created for smaller businesses with little credit history and rocky cash flow. After all, bridging gaps in cash flow is one of the most common purposes of unsecured business loans.
How are Secured and Unsecured Business Loans Different?
Before weighing pros and cons of each option, you should ask yourself two very important questions to make this process a lot quicker.
The first concerns the amount of money you intend to borrow. Institutions that distribute larger amounts (i.e. over $250,000) may only offer secured business loans. This is one of several reasons secured loans have higher standards for personal credit and cash flow.
Second, how quickly do you need the money? If you need money in your bank account in a matter of days, unsecured business loans are almost certainly your only option. Secured business loans typically require substantial paperwork and a more rigorous screening process. The institution must have the collateral appraised and assess a number of financial factors before trusting you with such a large amount of money.
Unsecured business loans, on the other hand, require minimal paperwork and can often be accessed in less than 24 hours.
Can You Use Secured Business Loans for Any Purpose?
Next, consider how you plan on using the money. Secured loans can sometimes be secured by the asset you intend to purchase with the borrowed funds. The most common example is new equipment. Purchasing the equipment gives the bank something to sell in the event of a default.
And since secured loans typically involve higher borrowing amounts, you may only be permitted to use the money for a specific purpose. If you planned on using the money for an arguably riskier investment, the institution might not have approved your application.
In contrast, unsecured business loans can be used for almost anything. You might not even have to tell the institution how you plan on using the money.
Which is Cheaper: Secured or Unsecured Business Loans?
If you’re still undecided, it’s time to think about additional pros and cons of each option. Let’s start with interest rates and terms. Secured business loans typically have lower rates and longer terms because there is less risk for the institution. The borrower’s collateral and personal credit give the institution two good reasons to trust them.
Unsecured business loans tend to have higher rates and shorter terms. But if you have strong personal credit and cash flow, you may very well be able to access rates and terms similar to those of secured business loans.
Other Advantages of Unsecured Business Loans
Aside from accessibility, one of the biggest advantages of unsecured business loans is flexible repayment options. Virtually all secured business loans have the same repayment system. The borrower makes fixed payments every month for a set term. With unsecured business loans, you may be able to choose from a series of payment frequencies (i.e. weekly, bi-weekly, daily).
Some types of unsecured business loans also carry completely different repayment structures. Examples include a merchant cash advance, business cash advance, and a business line of credit. For instance, the size of your payment for a business cash advance is directly based on monthly revenue. With a business line of credit, you only make payments when you draw funds from your credit line. These repayment structures may better suit businesses that don’t want to make the same payment every month, regardless of their financial health.
What are the Risks of Unsecured Business Loans?
The risk of secured business loans is clear. If you default, you will lose the asset you provided as collateral. That’s a risk that many borrowers aren’t willing to take.
However, this doesn’t mean unsecured business loans don’t carry risks of their own. The institution may charge steep fees for missing a payment, or make you sign a personal guarantee. Signing a personal guarantee makes the borrower personally responsible for paying back the loan in the event of a default. In other words, you wouldn’t lose a specific asset but you would have to gradually pay off the loan yourself. Institutions that offer unsecured business loans might charge more fees in general due to the higher risk on their behalf.
Another risk of unsecured business loans goes by the phrase “stacking.” Since unsecured business loans are so accessible, someone could theoretically take out multiple loans at the same time from different institutions. At some point, the business will have accrued so much debt that it will no longer be able to access financing. That is, if the mounting monthly payments haven’t already sent the business into bankruptcy.
Making Your Decision
You may conclude that you meet every requirement for a secured business loan, aside from collateral. Thankfully, businesses no longer need collateral to access competitive rates and terms along with high borrowing amounts. Plenty of institutions offer unsecured business loans with rates and terms based entirely on your cash flow and credit score. Therefore, if you’re looking for the most advantageous business loans on the market, focus on improving these two things above anything else. A lack of expensive assets will not stop you from eventually obtaining all the money you need to grow your business.