As a small business owner, it's likely that you've found yourself in need of additional financing to cover startup costs, hire more employees, purchase additional inventory or cover some other monetary need.
According to the 2019 Small Business Profile released by the U.S. Small Business Administration Office of Advocacy, approximately 6.1 million loans worth under $100,000 were issued to small businesses by American lending institutions. Similarly, the 2018 Federal Reserve Small Business Credit Survey estimated that approximately 71% of the 12,000 small businesses surveyed sought $100,000 or less in funding, with loans or lines of credit being the most common form of financing.
Lenders typically offer two main types of funding: secured loans and unsecured loans. But which type of loan is right for your business? Understanding the key differences between the two could be the difference between a safe infusion of cash and a costly financial miscalculation.
What is an unsecured business loan?
The biggest difference between secured and unsecured business loans is that the latter doesn't require the borrower to provide any collateral against the amount they're borrowing. In fact, Jeff Fazio, head of small business specialists at TD Bank, said that type of loan is "strictly backed by the borrower's creditworthiness."
"Small businesses typically seek an unsecured loan when they either cannot qualify for a traditional loan or can't negotiate better repayment terms with another lender," Fazio said. "The personal guarantee terms that are outlined within unsecured loans can be very generous for borrowers, but any default can have long-term ramifications that outweigh benefits like negative effects to your business's credit score."
Because an unsecured business loan is better for the borrower, the lender generally charges much higher interest rates than they would for a loan backed by collateral. This kind of loan is also much harder to obtain as a result. The inherent risk involved in an unsecured business loan naturally means it will generally be offered as a short-term loan to alleviate the lender's risk.
To qualify for an unsecured business loan, Fazio says, your small business needs to be able to "show the lender a good credit rating, a solid financial history and a cash flow forecast." He pointed out that it's rare for a traditional lender to approve an unsecured loan, with most of those kinds of lending agreements coming from online lenders.
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Benefits of unsecured business loans
If your business has enough financial goodwill in the form of a strong credit score and you can afford the interest rates, there are some benefits to obtaining an unsecured business loan.
The first and most immediately apparent advantage is that you don't need collateral. Usually, lenders want borrowers to put up valuable items like real estate, vehicles, or intangible assets like investment portfolios and business trademarks as backing for the loan. Without the need to put those items at risk of seizure by the lending institution, you can rest easy knowing you won't lose them if something goes awry.
However, items can ultimately be seized by the lender if they're included in the personal guarantee that every lender must sign to obtain an unsecured business loan. Such an agreement is legally binding, after all.
Unsecured business loans usually require less paperwork, skip the appraisal process for any collateral and thus have a speedier process overall. Unsecured business loans are also discharged in the event your company goes bankrupt, which isn't the case for secured business loans. [Read Related: How to Choose a Loan Provider]
Risks associated with unsecured small business loans
While the benefits may seem worthwhile, there are some major caveats that you should consider when looking to obtain an unsecured business loan. First and foremost, you may not even qualify for one.
Banks heavily rely on your personal or business's credit score to determine whether they're willing to offer you any type of loan, but given the high-risk nature of unsecured business loans, the bar is set much higher. While there's no minimum credit score you need for a short-term business loan like this, a lower credit score tells the lender that you may have a harder time paying the loan back.
If your personal credit isn't great, your business has a less-than-stellar credit history or your bad credit regularly keeps you from getting a credit card, let alone some other type of cash advance, your loan application likely won't land you any additional business financing opportunities anyway. It will always be harder to borrow money if you have trouble making your monthly payments. [Read Related: Small Business Loan vs. Cash Advance]
If your business needs a large amount of funds, you likely won't be able to get as much as you need through an unsecured loan, which generally only offers smaller amounts. Again, because there is no collateral to back the loan, banks are less inclined to go out on a limb and provide large sums of money.
Furthermore, an unsecured business loan may not be right for you simply based on how significantly higher interest rates are for this type of loan. The rates are almost always higher than those of some major credit cards, with some lenders charging a 100% APR. How high that figure ends up being depends on your credit score.
"Given a lender takes more of the risk involved in granting the unsecured loan, interest rates are high for borrowers," Fazio said. "With unsecured business loans, we often find the borrower might default and not have the means to repay the loan."
This brings us to the biggest warning, which really should apply to any borrowing you may be considering – defaulting on an unsecured loan means big trouble for you and your business. Even though you don't put up any collateral, minimizing the risk for the lender, there are other ways that failure to pay back your loan could cause major financial problems for you.
If you default on an unsecured business loan, your personal and your business's credit score will take a major hit. Also, just because you didn't put up specific collateral doesn't mean you won't lose any assets. The lender can sue you and your business for not only the balance of the loan but interest and other costs as well. Your business's bank accounts can be garnished, liens can be placed on your business's assets, and all that can happen in months.