Secured VS Unsecured Business Loans: Which Is Better For Your Business?
A secured loan requires collateral and an unsecured loan might require a high credit score. Which one is the best fit for funding your small business?
In your search to find business funding that’s the best fit for your small business, you might have read the terms of secured and unsecured loans.
The difference between a secured and an unsecured loan seems pretty straightforward — the former is backed by an asset that secures the loan for the lender, whereas the latter doesn’t. (You might have heard of assets that secure loans as collateral.) But if you get an unsecured loan, you’re still on the hook if your business fails — it isn’t just your business credit that will be affected.
So when is one better than the other, and how should you decide which to choose?
Here’s everything you need to know about secured and unsecured loans.
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What Is A Secured Loan?
- Borrowing fees and loan terms are more borrower-friendly compared to those of unsecured loans.
- Offering valuable collateral can give business owners access to a larger loan amount with lower interest.
- You only stand to lose the assets you put forth as collateral in the event that you default.
- You could lose whatever collateral you put down for the loan in the event that you default.
- Startups and businesses that don’t have any significant assets usually cannot access secured loans.
If you’ve accumulated valuable assets but haven’t had much time to build up strong business credit, a secured loan could be a solid business decision, especially if you’re capable of responsibly managing your payments.
Let’s look at secured loans in more detail.
How Does A Secured Loan Work?
A secured loan is when the lender grants you a loan in exchange for some sort of asset they can possess and resell in the event that you can no longer repay your loan. These claimable assets you own are commonly referred to as collateral.
Lenders consider these loans less risky precisely because they stand to gain the assets you set up as security.
As long as you have collateral equal in value to the amount of money you’re attempting to borrow, you can acquire loans at competitive rates. So if you make your payments consistently and on time, the lower interest on the loan will cut down your expenses in the long run.
Examples Of Secured Loans
Mortgages and auto loans are very common examples of secured loans. Assuming the homeowner is no longer able to pay their mortgage, the bank can repossess the house to recoup their losses. The same applies when you’re financing a vehicle. If you can no longer pay your auto loan, the bank will repossess the car.
In the case of a business loan specifically, a restaurant owner who owns the building might put up that property as collateral. The cash in a business bank account can also be used as collateral for a secured loan.
Altogether, the typical assets used to secure a loan include:
- Real estate
- Accounts retrievable
- Stocks, bonds, and similar securities
Limits On Secured Loans
Of course, restrictions apply — lenders won’t accept anything and everything as collateral. So, for example, if you were to attempt to secure your loan with a paid-off vehicle as collateral, the lender may not accept it if the vehicle is too old or has otherwise diminished significantly in value over time.
Established businesses that have valuable collateral they can put up are typically eligible for secured loans, whereas startups and newer businesses usually may have a harder time getting qualified.
Where To Get Secured Loans
Traditional lending institutions such as banks and credit unions, including SBA loans and lenders, typically offer secured loans. Equipment loans offered by vendors and equipment financing companies count as well since your loan is secured by the equipment you’re paying off.
Some online lenders also offer secured loans, though many online lenders only require a blanket lien on your assets, which, while not requiring any specific collateral, has more potential downsides for a borrower than a traditionally secured loan.
What Is An Unsecured Loan?
- Unsecured loans are easier to get — you can qualify even if you don’t have any compelling business assets.
- If you are an LLC and the loan doesn’t require a personal guarantee, you have a bit more financial protection (though most unsecured loans do require a personal guarantee).
- Financing is more expensive compared to secured loans.
- You’ll usually have less time to repay the loan.
- An unsecured loan may require a personal guarantee, so the responsibility to repay the loan falls on you if your business’s income can’t keep up with payments.
- You typically have access to less capital compared to secured loans.
Contrary to secured loans, unsecured loans are not backed by any specific collateral.
Besides this, there are a few things to consider if you decide this is the type of loan you’re going to pursue.
How Does An Unsecured Loan Work?
The lender will base their decision to lend you money on your creditworthiness and/or the strength of your business’s cash flow. (If you’re unsure of your credit score, check out these free credit score services.)
More often than not, you’ll need a good credit score — 670 at the very least — in order to qualify.
If you don’t have an established history of business credit, your personal credit score can also be taken into account. This depends on the lender you’re consulting with.
Because it’s much more difficult to reclaim money if you default on the loan, unsecured loans are much riskier than secured loans. And the riskier the loan, the more it’s going to cost you.
Secured Loans VS. Unsecured Loans: Key Differences
For starters, unsecured loans have higher interest rates than secured loans. And since lenders won’t want to risk too much on you, expect access to less money overall.
Many lenders mitigate their risk by requiring businesses to have been in operation for a few years and to have a healthy cash flow. After all, it’s difficult to determine the creditworthiness of a business that doesn’t have an established track record.
Limits On Unsecured Loans
Your income, savings, and outstanding debt play a huge role in how much money you’re qualified to receive. Credit history is more important with an unsecured loan than a secured loan since lenders need to trust that you can make them whole as opposed to an asset they can claim.
Also, it’s important to realize that even though a loan may be unsecured, lenders typically require a personal guarantee.
A personal guarantee is an agreement that states that if the business can no longer repay the loan, whoever signed the personal guarantee is personally responsible for repaying the remaining balance.
Lenders can advertise a loan as unsecured as long as they don’t require collateral for you to qualify. The catch is that your personal assets and savings are on the line if your business can’t muster up payments. Know that if you’re the owner of a sole proprietorship or general partnership, you are already personally responsible for repaying all business debts.
Where To Get Unsecured Loans
These are some types of lenders that offer unsecured loans that can be used to finance a business:
- Short-term online lenders
- Online lines of credit
- Personal lenders for business
- Credit cards
- Some nonprofit lenders
Is A Secured Or An Unsecured Loan Right For You?
If you come across a lender that’s advertising unsecured loans, be aware that your personal money and assets will probably still be on the hook. Lenders won’t give your business any sort of capital unless they know for sure they can get the money back.
You should really only apply for an unsecured loan when you have a stellar credit score and a low debt-to-income ratio. A secured loan is likely your best bet in all other instances.
However, if your business can’t get a bank loan because you don’t have collateral, take a look at some of our best small business loans. (Note that the majority require a personal guarantee.)
These loans are not quite as good as those you could get from a bank, but they’re the next best thing.
When You Should Get A Secured Business Loan
- You have specific collateral you can offer to secure your loan.
- You are prepared to lose this collateral if you default on your loan.
When You Should Get An Unsecured Business Loan
- You do not own specific assets that would qualify you for a secured business loan.
- You understand the risks of signing a personal guarantee.