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Secure vs. Unsecured Business Loans
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.
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:
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:
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:
Secured loans usually offer these benefits:
There are also some drawbacks of secured loans:
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.
In contrast to a secured loan, here are some benefits of unsecured loans:
Here’s a summary of the drawbacks of unsecured loans:
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.
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:
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:
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).
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.
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.)
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. - Link to the small biz funding guide ]