Secured Versus Unsecured Business Loans: Everything SMBs Need To Know
There are two basic types of bank loans that every business owner should be familiar with before signing on the dotted line: secured and unsecured loans.
A secured loan places the burden of risk of on the borrower. An unsecured loan shifts the burden of risk more to the lender. Which type of loan you get, and the loans available to you, all depends on a number of factors, ranging from what type of lender you work with, what assets you own, and your plan for the funds, to your credit history and business health.
In this guide, we’ll explain the differences between secured and unsecured loans, and how to prepare for a loan application.
What is a Secured Loan?
Secured loans are loans that are backed up with some form of collateral. Collateral is something pledged as “security” for repayment of a loan. In the event that you cannot repay your loan, you may lose the collateral.
Collateral for a secured loan can take the form of the item you are purchasing, such your property or your business-related equipment. It’s similar to when you take out a loan to buy a house, the bank (or finance company) will keep the deed to your home until you repay the loan, including interest and any fees. If you are not able to make your payments, the bank can put a lien on your house. Other assets can also serve as collateral to secure a loan, including personal property, even stocks and bonds.
Often, a home serves as a reliable form of collateral because banks understand that people will generally do whatever is necessary to maintain their home. This doesn’t always hold true, however, as the subprime mortgages underlying the Global Financial Collapse demonstrated. In that case, borrowers who couldn’t afford their new houses simply walked away and cut their losses, having invested next to nothing. But again, the idea behind a secured loan is that the asset the borrower is putting up as collateral is something of value that the person will work hard to prevent from losing to the bank.
If you take out a loan to buy business-related assets, but default on your payments, the finance company may repossess the assets and resell them. It will then deduct that portion of your debt from the total and seek out legal recourse to get the remainder of what it loaned to you.
Often, if you’re seeking a substantial amount of money, secured loans will be your main option. Lenders are more likely to loan larger sums of money if there is valuable collateral backing up the loan.
Examples of Secured Loans:
Mortgages. These loans for property are secured with the property itself.
Construction loans. These are loans to help you build on land that you own, and are also secured with the property.
Auto loans. These loans are helpful when making a major vehicle purchase, and are secured with the vehicle.
Home equity line of credit. This is another type of loan that you can secure with your home.
What is an Unsecured Loan?
An unsecured loan is a loan that a lender issues, supported only by the borrower’s creditworthiness, rather than by any type of collateral.
Banks and other above-board financial lenders also offer unsecured loans, which are generally provided for credit card purchases, education loans, some property improvement loans, and personal loans, often called signature loans. Typically, it’s very hard to get approved for these loans unless you have a strong credit history and a reliable stream of income.
Because the lender relies on your agreement rather than collateral assets associated with your business, loan terms are going to reflect that risk. Expect a considerably higher interest rate. Furthermore, the lender may want the money back in a timelier fashion, and might be less inclined to offer a larger amount since there is nothing of yours to seize if you don’t pay back what you owe.
Examples of Unsecured Loans:
Credit cards are the most common example of unsecured loan instruments. Every time you pay for something with a credit card backed by a financial institution, that institution is really giving you an unsecured loan, on the spot. They previously determined your creditworthiness, and gave you a credit limit, when they approved you for the card.
Signature loans. When you have a good relationship with a bank, you may be able to get a “signature” loan. This is an unsecured loan that relies on a good faith assessment of the borrower’s character and promise to repay the funds.
Student loans. While these don’t really apply to funding for your small business, they are a good example of unsecured loans. While students don’t have to provide any collateral in order to get a student loan, they do risk things like garnished tax refunds or wages in the future if they are unable to make their loan payments.
What is Collateral?
Collateral is defined as something pledged as security for repayment of a loan, to be forfeited in the event of a default.
Collateral may take the form of business or personal assets, real property, or another big item that you will purchase with the loan if you are approved.
You may have seen many late-night ads targeting homeowners offering home equity loans. These are also a type of secured loan. In this case, lenders are looking to find people to borrow against property that they already own, rather than for a new purchase.
Lenders base unsecured loans on the equity that you have in your property. That’s a simple formula: the current market value of the property minus the debt still owed on it. And the property, of course, functions as the collateral for a cash loan.
Examples of Collateral For Secured Loans:
Houses, offices, land, or other real estate
Large and valuable personal property items like cars
Jewelry, watches, rare collections or other valuable personal items
Financial property such as stocks and bonds
Cash in the bank. Yes, you can provide cash as collateral to borrow more cash.
Any asset that could be converted into cash to pay off the loan
Pros and Cons of Secured Loans
Secured loans usually offer these benefits:
Lower interest rates
Higher borrowing limits
Longer repayment terms
There are also some drawbacks of secured loans:
You will need to provide some assets to “secure” the loan, either cash in the bank, or valuable collateral like a house or vehicle.
If you provide collateral, you risk losing it to the lender if you aren’t able to pay back the loan.
Longer repayment terms might be considered a pro or a con, depending on your point of view; with longer repayment terms, you will be in debt longer.
In essence, these benefits are what you are “buying” with your collateral. By putting your personal assets on the line, you are usually able to secure better terms from your lender.
In this sense, a secured loan provides each side something it values. For the lender, it assures that there is a valuable asset ensuring repayment, which then allows the lender to feel secure enough to provide a more favorable deal.
To drive home this point, consider one possible alternative for a borrower without collateral. That person might turn to an unscrupulous player in the finance industry: the so-called “loan shark” or unregulated predatory lender.
A loan shark does not take any collateral to offset their risk. In return, they tend to offer some very unfavorable terms, most likely including a very high interest rate (in the movies, they often call this the “vig”) and a shorter repayment period.
The above scenario is, of course, just one example of an unsecured loan, but it’s (hopefully!) not the sort that you’re relying on for your business.
Pros and Cons of Unsecured Loans
In contrast to a secured loan, here are some benefits of unsecured loans:
You don’t need to provide collateral.
You won’t risk losing your collateral since you aren’t providing any.
It is often easier to borrow small amounts of money with unsecured loans.
Here’s a summary of the drawbacks of unsecured loans:
Higher interest rates
Smaller borrowing amounts
Shorter repayment terms
The major drawback to unsecured loans is liability. You aren’t providing collateral, but you can be personally liable for the loan. That means, if you don’t pay back the loan, your lender could sue you and come after your personal assets anyway. If you lose such a lawsuit, you might face consequences like garnished wages or loss of other personal property.
As discussed above, unsecured loans often come with shorter repayment terms, higher interest rates, and smaller loan amounts. While all of these could be big drawbacks, they might not be. The type of loan you choose will depend on your situation, how much time you need to pay back the loan, and how much you want to borrow.
Secured vs Unsecured Loans: Which is Right for You?
Which type of loan is right for you depends largely on the circumstances you’re in and what your goals are. Keep in mind that a secured loan is normally easier to get, as it’s a safer venture for the lender. This is especially true if you have a poor credit history or no credit history. If that’s the case, lenders justifiably want some kind of reassurance that they’re not just gambling with their money (which, when you get right down to it, is other people’s money that they’re investing ideally in responsible loans).
A secured loan will tend to include better terms, such as lower interest rates, higher borrowing limits, and, as discussed above, longer repayment schedules.
Then again, maybe you don’t have or want to provide collateral. Perhaps you’re more concerned with just weathering a storm, and you’re not worried about paying a higher interest rate. Or maybe you plan to pay back the money immediately, in which case, you’re not concerned interest or a lengthy payment plan. And assuming you don’t need a small fortune, the higher borrowing limit might not be a feature that you care about. In these cases, you might prefer an unsecured loan.
How Do I Get a Secured Loan? How do I Get an Unsecured Loan?
Whether it’s a secured or an unsecured loan that you seek, the bank or lending agency is going to be looking at your creditworthiness. When a bank denies a small business loan application, nearly half of the time (45%, according to multiple Federal Reserve banks), the lender makes that decision as a result of a poor credit score.
For borrowers with a lower credit rating who do manage to get a loan, they can expect to pay higher-than-normal interest rates and premiums, and get stricter payment terms than those borrowers with high credit scores.
In addition to getting better terms, there’s another reason to build strong credit: it may allow you the luxury of choice between a secured and unsecured loan. If you’re concerned about putting up any of your personal assets as collateral, then you’ll definitely appreciate having that choice. Having strong credit could provide the opportunity to sign an unsecured loan with more attractive terms, mitigating your personal risk.
Here are some things you will need to decide in order to obtain a loan:
Purpose of the loan: Decide how you want to use the loan. All reasons are not equal; if you’re using the money to upgrade your technology or buy more property to expand your business, lenders will look more favorably on those uses, as opposed to spending the money to pay off a separate loan or on non-essential business assets.
Amount of funds: Determine how much money you need. Aim too low, and you’ll be applying for another loan again soon, as the lender questions your business acumen. Also, you might find that many lenders, especially banks, simply don’t lend small amounts. Overestimate, and lenders might be wary of your economic responsibility.
Choose a lender. Determine which type of lender is most suitable for the needs of your business: bank, non-bank lender, crowdsourcing, or alternative investment sites. (Want a detailed overview of popular small business funding options? Check out our in-depth guide to small business funding.)
Paperwork: Prepare the loan application package, making sure to complete all of the requirements. Provide data to demonstrate you’ve done your research to reach sound financial conclusions. Include a business plan with a budget based on reasonable projections, resume, profit & loss statements, balance sheets, cash flow statements, and personal financial information with three years’ tax returns.
How Do Lenders Assess Creditworthiness?
Both types of credit loans — secured and unsecured — create fodder, for better or worse, for your credit score. Financial lenders report your payment history to the credit bureaus. If you’re looking to avoid blemishes, beware of late payments and defaults.
If you default on a secured loan, of course, the lender may repossess whatever you bought with the loan (please don’t tell me it was a boat), or, if it was a house, foreclose on it. Those don’t look good on your credit score, either, by the way.
There are five criteria, known as the Five C’s, that financial institutions often look for in determining the merit of the borrower on the basis of the person’s financial history and resources. We’ve covered them in more detail here, but here they are in brief.
The 5 C’s of Creditworthiness:
Character. Your lender will evaluate your “character” using both objective and subjective measures, including your credit score, your business history, your business plan if you’ve submitted one, and any publicly available information, such as customer reviews. Your public reputation is definitely a factor in how likely the lender judges you are to repay your loan.
Capacity. This “C” could also be described as “Cash flow.” The amount of revenue coming in to your business will have an impact on how your lender judges your ability to repay a loan. If you’ve got a steady and predictable revenue stream, that looks great to a lender.
Capital. Have you made significant financial investments in your business over the years? If you’ve invested your own capital in your business venture, that’s a good sign to a lender. Lenders typically prefer it when business owners have plenty of “skin in the game”.
Collateral. Collateral means assets. We covered this in detail back in the section about collateral. This is a key part of getting any secured loan.
Conditions. This refers to conditions that are unique to your situation and the overall economic environment. Lenders will want to know how you intend to use the loan, and they will consider whether you are likely to succeed in your business ventures, given the current economic environment.
These are characteristics financial institutions use to determine the borrower’s likelihood to repay the loan (below, we’ll discuss how to increase your creditworthiness).
How to Improve Your Chances of Getting a Loan
Now that you have a good idea about the differences between secured loans and unsecured loans, as well as what’s important in order to get approved for a loan, you’re ready for the next step. That is, making sure you’re in the best possible position, should you decide to apply for a loan. Improving your business credit and maintaining a good credit score is important to improve your chances of getting approved for a loan.
Here are some ways to help build (or improve) your business credit score:
Don’t wait until you need cash fast before you prepare. Because a longer credit history is better than a brief one, the sooner you begin to establish your credit, the longer your credit history will be when you need a loan. And, as a result, your score will be better. Not all lenders will need your personal credit score, but if you’re planning to apply for a bank loan, you’ll need a good score.
Or at least, don’t be late. Banks take deadlines very seriously. While fees are hassle enough, they are not nearly as bad as the harm that banks can do to your credit score. Some lenders refuse to issue a perfect credit score to a borrower who doesn’t pay before the payment is actually due; paying early is sometimes the only way to ensure a top score.
Maintain a Good Record
Financial lenders have access to a lot of information that you might have thought was private. Keep in mind that your business credit report contains any publicly filed record under your DBA. That, of course, includes any liens, judgments, or bankruptcies, which all affect your credit rating for the worse. For instance, Experian keeps a bankruptcy on your credit score for about a decade. Liens and judgments can still haunt you for about seven years.
Your Personal Credit is also Important to Banks
A lender will usually judge your personal level of responsibility when it comes to handling credit. If you’re imprudent with your own credit, then why, their thinking goes, would you be any more responsible with your company’s finances? This is the reason why banks want your personal credit score in order to consider you for a loan. This is pretty frustrating for many small business owners, since it’s quite possible to have a thriving, healthy business but no personal credit. Personal credit scores are only a small part of the bigger financial picture, but for now, that’s just the way big banks do business.
Stay on Top of Your Data
If you discover a problem of any kind — whether it be a simple miscalculation or nefarious fraud — report it on the double by filing a dispute with your credit bureau. Errors of any kind can and will affect your credit score, and the only defense you have is your own vigilance. Fortunately, there are credit monitoring services out there that can help you keep an eye on things by alerting you to suspicious credit activity, or a drop in your score. Resolve any mistakes you find or suspicious issues as soon as you can, or they might come back to haunt you at the worst possible time.
Secured vs. Unsecured Loans: Which Loan Should I Pay Down First?
If you’ve got both a secured loan and an unsecured loan, and you’re wondering which to pay down first, the secured loan, if often the better choice since it is tied to your property. If you don’t make the payment on your business’s delivery truck, for example, someone is going to come for the keys.
That said, the interest rates on an unsecured loan can be quite high. Sometimes, giving up the secured assets to keep from going bankrupt is simply the better option if don’t have an alternative. If you have multiple loans and are uncertain about how to proceed, your business accountant or financial advisor may be able to help. (If you don’t have one, read on.)
Getting Additional Help With Debt
If you are feeling overwhelmed by debt and you need more answers, consider contacting American Consumer Credit Counseling. They are a nonprofit organization that provides access to credit counselors. They provide free advice to help consumers find ways to more effectively manage their money and get out of debt. If you do need financial help with your debt problems, keep in mind that they offer a no-obligation consultation.
At some point down the line, your small business will likely require more money. Whether you are looking to build a new location or simply trying to meet next week’s payroll, your business will need an injection of cash. It’s critical to be able to get access to funds when you need them. If you choose to apply for a loan, getting approved requires preparing in advance, as well as managing and monitoring your credit.
Your creditworthiness will have a significant impact in determining your ability to secure a loan of any kind. But at least now, you should have a solid understanding of the differences between secured and unsecured loans, and the pros and cons of each.
Not sure if a secured or unsecured bank loan is the right choice for you? Read on for alternative methods and sources for small business funding here.