"Unsecured." The word in itself might cause anxiety for some. Generally, most people prefer something to be secured versus unsecured – the lock on their front door, their seat belt, their money in the bank. But, unsecured is not always a bad thing. In fact, when it comes to loans, unsecured business loans are often preferable to many business owners.
With a secured business loan, a business owner must put up a piece of personal collateral (usually their home, vehicle, or retirement account) that can be sold by the lender to cover the cost of the loan should the business default on payment. Unsecured loans do not require the borrower to put up any collateral. While keeping personal assets separate from business liabilities seems like the more desirable option, it can be difficult for new small business owners or those with a history of financial troubles to obtain an unsecured loan.
Secured vs. Unsecured: Which Is Right for My Business?
The adage, "It takes money to make money," is true. Many entrepreneurs need to take out some kind of debt, whether a loan or a line of credit, to invest in the materials necessary to start or grow their business. This can include manufacturing equipment, real estate, software, or inventory, depending on the unique needs of the business. To obtain a business loan, most traditional bank lenders require a business to show at least two years of successful operation and responsible credit usage (on-time payments, low debt ratio, etc.) Since most new companies can't do this, lenders require them to personally guarantee the loan, which means that the lender can take their personal assets to pay back the loan if the business defaults.
For some businesses, a secured loan is not even an option. If the owner or a co-signer does not have a good personal credit history or does not have any assets of value, most traditional lenders will not engage. Along these lines, the loan amount of a secured loan is usually tied to the value of the assets used to secure it. So, if a business owner's home is worth $250,000 and the business needs $500,000, a secured loan is probably not the answer (at least for the full amount).
While interest rates and terms vary based on the lender, the borrower's credit history and the timing, in most cases, secured business loans have lower interest rates than unsecured business loans. This is because, one way or another, the lender is guaranteed to be repaid with a secured loan. Higher interest rates usually signify a higher risk on the part of the lender. Secured loans often offer terms up to 30 years, but unsecured loans have much shorter terms, sometimes five years or fewer. Because of the shorter terms, monthly payments are much higher.
Unsecured loans generally offer higher loan amounts than their secured counterparts, along with a more rapid time to fund. While they bring flexibility to the business by way of a cash infusion, they usually have stricter repayment terms, including early repayment fees.
So, while an unsecured business loan might seem preferable at first glance, you need to weigh whether your business can handle shorter terms, higher monthly payments, higher interest rates, and less repayment flexibility. For many, a secured loan is simply not worth risking their home or other personal items of value, so your personal comfort with risk should be heavily considered.
How to Prepare Your Business to Obtain an Unsecured Loan
The first step to obtaining an unsecured loan is to work on your credit score. This includes your personal credit score, as well as that of your business. Do what you need to do to get your personal financial house in order. For your business, make sure it stands on its own as an entity by creating business-only banking accounts, taking care of necessary legal filings, registering for a business license, and setting up a dedicated phone number and mailing address. Work with your vendors and suppliers to establish terms. Open credit cards in the name of the business and use them, but not too much. Pay off all debt in a timely fashion. Monitor your business credit score and contest any errors you find. Without a good credit score, lenders are not likely to trust you with an unsecured loan. And if they do, it will come at the price of higher interest and less desirable terms.
Write a thorough and convincing business plan. Be sure to address how you intend to spend every cent of the money you are asking for. Present a strategy that shows how you will repay the loan.
When you start shopping for lenders, consider traditional banks, credit unions, online lenders, and other finance companies. Get several quotes before making any kind of commitment.
Do your homework and make sure you only work with reputable creditors. There are many predatory lenders out there that prey on businesses and individuals who are desperate for money and can't obtain it from a traditional bank lender due to bad credit or a lack of assets. Oftentimes, a loan with very short terms and a high interest rate is not worth the strain it puts on the business.
Once you find a lender, be sure to read the fine print on the loan contract carefully, because even though a loan might not be formally secured with personal assets, there are still instances where a lender is within its rights to pursue action against an individual business owner if the company defaults.
Really consider the health of business and your personal comfort with risk. While higher interest rates and shorter terms can be negative, so can losing your house along with your business. Be realistic about your company's future outlook, and determine whether a secured loan or an unsecured business loan will take you where you want to be.