So you want to get a loan. You’re certainly not alone. The majority of small businesses use financing to fund their growth and operations. While the path may seem obvious, there are plenty of important questions associated with this pursuit. For example, how quickly do you need the money? What will you use the money for? How long do you want to pay the money back?
Among these questions is a fundamental consideration that will impact the risk involved for both you and the lender. Will you get a secured loan or an unsecured loan? Both routes have advantages. Your decision will also help determine the amount of money you can borrow, the interest you will pay, the amount of time you’ll need to pay it back, and the consequences if you were to default.
The truth about secured business loans
A secured small business loan gets its name from the fact that you are “securing” the loan with collateral. Lenders prefer this option because it means if your business defaults, they still get some compensation and won’t be left high and dry.
When it comes to a secured loan, you’ll always need to put up collateral such as real estate, homes, vehicles, machinery, or accounts receivable. Lenders usually want the collateral to be of equal value to your loan amount. So you can’t just offer up a $5,000 fishing boat on your $500,000 business loan and think you’re good to go.
In some cases, the collateral may even need to be of a higher value than the loan since the cost for the lender to use your collateral to defray the costs associated with your loan can be pretty steep. For example, if you put up 5 acres of farmland as your collateral and then default on the loan, the lender would have plenty of work to do before recouping their money. They’d have to hire a real estate agent to list the property, wait until it sold, pay the agent, then finally collect the money they had earned on the sale.
Since there’s less risk for lenders with a secured loan, they’ll often return the favor by offering you a lower interest rate. Plus, you can expect the repayment terms to be longer. Ultimately, these loans are easier to obtain because lenders are more motivated to work with you when there’s a guarantee in place.
The truth about unsecured business loans
With unsecured financing, you don’t provide any collateral. This option keeps your motorcycle safely in your garage and your lake house off the chopping block. With no collateral to lower the lender’s risk, they’re required to assess your ability to repay the loan in full. The lender will most likely want to study your income, savings, credit history, and employment before deciding whether or not to grant the loan.
Given the higher risk, unsecured loans typically don’t exceed $50,000. It’s not surprising that they usually go to established companies, rather than young companies that don’t have a proven repayment history. As a rule of thumb, a company needs to have at least a 2-year track record and annual earnings of at least $100,000 to be in the running.
It should be noted that while unsecured loans don’t include collateral, some lenders will still ask for a personal guarantee. If your business is unable to repay the debt, you’ll be personally responsible for it.
For those who like the idea of an unsecured loan but don’t know if the constraints of a traditional loan are the best fit, it’s worth considering an unsecured business line of credit.
“An unsecured business line of credit is a great option if your business needs access to cash on demand,” explains SBA.gov. “Business owners want access to funds—whenever they need it, at a competitive rate, and with flexible payment options. The National Federation of Independent Businesses says, ‘Think of it as an insurance policy that never needs to be paid until you need it.’”
Qualifying for an unsecured business line of credit requires a healthy credit score, a proven personal financial history, and the kind of credit utilization ratio that puts a lender’s mind at ease. Additionally, you shouldn’t have too many hard inquiries on your credit in the past 6 months.
A final look at the pros and cons of both options
With a secured business loan, you definitely get some clear benefits. The loan amounts can be much larger because the lender will have faith they’ll get repaid one way or another. And the loans come with lower interest rates for that same reason. Additionally, you can sometimes even take tax deductions for the interest you pay to a secured loan in a given year.
The major drawback of these loans is that you have to put so much skin in the game. If your business fails, the lender could take hold of your prized possessions.
With an unsecured loan, you aren’t required to risk your private property. This option is particularly helpful if you don’t have possessions that would qualify as collateral. Also, you can count on the application process moving a lot quicker with an unsecured loan versus a secured loan.
On the flipside, the interest rates on unsecured loans can be substantially higher than those for secured loans. Higher rates are one way lenders try to mitigate their risk. Also, unsecured loans are quite difficult to qualify for unless your business has an established track record.
If you’re unsure of which loan option is best for you, it might be helpful to speak with one of Lendio’s small business financing experts. They can help you review your financial situation and make an educated decision for moving forward. The bottom line is, no matter your situation, there’s a small business loan out there for you.