Understanding Secured vs. Unsecured Business Loans
Growth for a business can be expected…or unexpected. As you research your options for small business financing to assist with the growth, you most likely have come across the terms “secured” and “unsecured” business loans and wondered what the difference is between them. Is one a safer option or a smarter option than the other? The difference between secured and unsecured business loans can be easily boiled down to one word: collateral. Whether or not you have collateral to offer up on your loan is the driving factor in choosing between the two. Here is a closer look at the differences between a secured and an unsecured loan.
What Is an Unsecured Business Loan?
Unlike a mortgage or auto loan, which allows your lender to use your home or car to recover funds in the case of default, unsecured loans are not tied to any collateral. Credit cards are an example of an unsecured loan. Student loans and personal lines of credit are other examples.
For small business owners, unsecured loans offer the opportunity to obtain a lump-sum working capital that can improve your cash flow. There is no collateral required against unsecured business loans, so lenders have nothing to recoup if the loan goes into default. For this reason, lenders have very stringent qualification standards. They look for a strong credit score and history of reliable credit payments.
What you’ll find when applying for an unsecured business loan is that lenders often charge higher interests due to the risk these loans carry. Additionally, these loans command shorter loan terms and will need to be repaid quickly. Facing a higher risk, lenders want their money repaid in a shorter time-frame.
What Are Secured Loans?
As mentioned above, unsecured loans are an option for small business owners with a strong credit score and financial history. However, if your credit is not as good, you still have lending options available to you. In this instance, secured loans are a safe alternative to explore.
Business owners often use the funds from secured loans to expand their business – such as new equipment, new operating space, or new employees – or as a way to refinance their business debt. To obtain a secured loan, you will be asked to put up collateral that your lender will use as an “insurance policy” for your loan. If you default on your loan, the lender will take ownership of the collateral and sell it to recoup their losses. For a secured small business loan, you can use real estate, equipment, inventory, or personal cash as collateral.
Because you have collateral as a back-up, lenders are willing to offer larger loan amounts and lower interest rates on secured loans. As a safer credit risk, you’ll also have longer loan repayment terms.
It is important to note, however, that your collateral will most likely be estimated below value. You may have paid $35,000 for a company vehicle, but it doesn’t mean the bank will consider it as $35,000 in collateral. If necessary, your lender will need to liquidate it quickly to recoup losses, which means selling it at a lower price, so they will value collateral accordingly.
The Role of the Guarantor in Secured and Unsecured Loans
Regardless of whether you obtain a secured or unsecured loan, as a principal of the company you will be required to act as a personal guarantor. In this role, you are personally liable for the loan if it cannot be repaid. The lender can take control of your personal assets if business assets cannot cover the remaining payments. These can include your home, cars, retirement savings or other assets.
As a business owner, if you are hesitant about acting as a personal guarantor, you may want to look into other options for financing your business other than a loan.
Should You Choose a Secured or Unsecured Business Loan?
A final bit of advice from Phil Fry, Business Lending Manager at Diamond Credit Union. “Business owners shouldn’t get too hung up about whether to get a secured loan or an unsecured loan or which rates are higher or lower,” says Fry. He recommends that business owners focus on submitting a strong application and providing clear, current financial information, both personally and for their business. With this, a lender can see a clear picture and if you qualify for a business loan, then they will offer the best loan for your situation.