Starting a business brings with it a host of new decisions. Should you structure it as a sole proprietorship, partnership, corporation, S corporation, or a Limited Liability Company (LLC)? Will you operate exclusively online, or would it be better to also have a brick-and-mortar location?
If you use debt financing as a way to fund your business, you’ll also need to consider what type of loan to pursue. There are diverse options, including business lines of credit, short term loans, business term loans, equipment financing, business acquisition loans, SBA loans, and startup loans.
Business loans can be secured or unsecured. A secured loan is backed by collateral like property, equipment, or other business assets of value. An unsecured loan is based on creditworthiness alone and leaves a lender unprotected if the loan is not repaid.
Secured business loans typically have lower interest rates than unsecured loans because if the borrower defaults on the loan, the lender can seize property to recoup the loss. Unsecured loans have higher rates because a lender has no recourse in the event of non-repayment.
Entrepreneurs have more skin in the game with a secured business loan, meaning they offer up a personal asset to cover the cost of the loan if they’re unable to make their payments. Common examples of collateral include homes, cars, stocks, bonds, real estate, inventory, or equipment.
The value of the collateral needs to match at least the value of the loan. In some cases, lenders will ask for the collateral to exceed the loan amount because some forms of collateral, such as real estate, take substantial time and effort to convert into cash.
For example, if you used a 5-acre lot as collateral and then defaulted on the loan, the lender wouldn’t simply keep the property as a memento. They’d try to sell the lot, which would require them to jump through various hoops. Upon the sale of the property, the lender would take enough money to cover the amount you owe and then give you the remainder.
It’s important to obtain an accurate estimate for the asset’s value before talking with your lender. They will be inclined to undervalue it because they prefer to liquidate assets in a hurry, which is done at lower-than-usual prices. If you’re prepared with a recent estimate, you’ll be better able to negotiate with them.
As you might expect, lenders are more generous when their risk is lowered. For starters, the qualification standards for a secured loan are more lenient than with an unsecured loan. So if your business is new or you have less-than-stellar credit, this option is your best bet.
Secured loans have higher dollar amounts than unsecured loans, making them ideal for larger projects and initiatives, such as buying equipment or financing purchase orders. The repayment terms and interest rates can also be more favorable to borrowers, meaning you’ll have more time to repay the loan. And the lower monthly payments will help to increase your cash on hand for inventory, staffing, and other expenses related to running your business.
What is a secured business loan’s main drawback? The fact that you’re personally liable for the money you’ve borrowed. If something were to go wrong, your collateral would belong to the lender. For this reason, it’s essential that you only seek loans you can confidently repay—and only offer up collateral that you could tolerate losing if things were to go south.
No collateral is involved with an unsecured business loan, meaning the lender faces higher risk. Because of this scenario, the lender will go over your credit score with a fine-tooth comb. They’ll also pay close attention to the financial history of your company, meaning new businesses seldom qualify. If you don’t have a robust credit history, balance sheets, cash flow, and cash reserves, lenders simply won’t have enough data to make an educated decision.
For businesses with a track record of 2 or more years and annual earnings that reach at least 6 figures, an unsecured business loan can be an excellent choice. Because no collateral is required, you won’t need to put your personal assets on the chopping block. The absence of collateral also simplifies and accelerates the application process, as there won’t be analysis and dialogue involving the collateral to be used.
The dollar amounts for unsecured loans usually max out at $50,000, so this type of financing is best suited for smaller expenses. As you forecast your finances, remember that you’ll also need to account for the higher interest rates and shorter repayment terms typical of unsecured loans.
If you meet the lender’s qualifications and have financing needs in the range of what an unsecured business loan provides, this avenue can be a solid option. It’s a streamlined way to obtain low-risk money for your business.
The bottom line is that you have numerous choices when it comes to obtaining a loan for your business. There’s no silver bullet that’s best for all situations, so it’s crucial for you to consider every angle carefully before you begin submitting applications.
In most cases, the strength of your finances and the amount of money you need to borrow will dictate whether you go with a secured or unsecured business loan. From there, you’ll just need to decide which lender and loan product best match your needs.
Start preparing now so you’ll be ready to roll when you find the right loan. Get your business plan dialed in, ensure your credit score is accurate, and assemble the required documents. Any effort you put into getting yourself ready can potentially save you hours of work when it comes time to click submit on your chosen application. Plus, your preparations will foster confidence, which is one of the most crucial elements of any successful loan application.