Secured business loans are the most common and straight-forward kind of lending because they are backed by an asset, such as equipment or real estate. If the borrower defaults, the lender assumes ownership of the property and may try to recoup their loss by selling it. Types of collateral that may be pledged for a loan include personal cash and property, unpaid invoices, inventory and even a lien on your business.
Business owners may opt for this option if they want to limit their personal risk in the investment, or want lower interest rates and the ability to pay back the investment over longer periods of time.
Pros: Banks will typically be more willing to work with you when their investment is somewhat assured. For large purchases that you do not expect to pay off quickly such as real estate, secured loans may allow you to pay over time, up to 30 years. Since secured loans represent less risk for the lender, there may also be some leeway if you accidentally miss, or are late with, a payment.
Cons: Secured loans are limited by the fair value of the asset pledged as collateral. Taking out a secured loan means you are giving the lender legal permission to seize the asset if you are not able to make payments according to schedule without a court order.
For business owners with strong personal credit, unsecured business loans, which are not backed by collateral, may be an option. However, this type of financing represents more risk to the lender. If the borrower defaults, there is no asset to seize. For this reason, unsecured loans typically come with stringent qualification standards and higher interest rates. Banks may also require a different security feature as an alternative to collateral – such as a percentage of your credit card transactions.
If you default on an unsecured loan, the bank may pursue legal action against you, employ a collection agency, or sell your outstanding debt to a third-party who will come after you. Some unsecured loans require a personal guarantee, which means banks will be able to appropriate your assets if your business defaults on the loan. This option is best for entrepreneurs who need large amounts of cash quickly, and expect to pay it off in a short time.
Pros: Unlike the secured kind, unsecured business loans are not bound by the value of the underlying asset. Not having collateral also bypasses lengthy appraisal processes, which means you could get the cash you need sooner. In the event your business files for bankruptcy, unsecured loans also have the potential to be forgiven.
Cons: This form of financing is typically more expensive and often come with short repayment periods. It’s also much harder to qualify. Lenders will want to know that your business has been around for several years with strong revenues or positive cash flow, and the individual has excellent personal credit history. Defaulting on unsecured business loans can mean financial ruin and damaged credit for both the business and its owner.
Conclusion: Secured vs. Unsecured Loan
For new businesses or entrepreneurs who are just starting out, secured business loans may be the only option available. For established business owners willing to pay higher interest rates, unsecured credit can offer more flexibility, larger amounts and faster access to cash. However, they may be held personally accountable if the business defaults.
Entrepreneurs may also want to consider partially secured loans, where collateral is required but does not have to cover the principle. Lenders assume less risk with these types of loans because they are typically not discharged by bankruptcy, and the pledged asset guarantees some return in the event of default. Banks may therefore offer more attractive terms for partially-secured loans than unsecured, such as lower interest rates and longer repayment time.