Small business loans can help business owners with startup costs, expanding operations, purchasing inventory, and funding day-to-day operations. If you’ve already started looking for a loan for your small business, you may have encountered the terms secured and unsecured loans.
What is the difference and which of the two is ideal for your business? Knowing the difference between secured and unsecured options can help you select the best one for your business.
Secured business loans usually require collateral and may provide larger amounts with lower interest rates. Therefore, they’re ideal if you have assets to back them. Unsecured loans, on the other hand, don’t require collateral but may come with lower borrowing limits and higher interest rates because they’re a risk for lenders.
Deciding which option is best requires a thorough examination of your specific financial needs, business’s financial health, timeline, and long-term goals. This article provides a detailed breakdown of secured vs. unsecured loans to help you make the best decision for your business.
What Is the Difference Between a Secured and Unsecured Loan?
Both secured loans and unsecured loans have their own benefits and drawbacks. We outline each type below as well as examples of each so that you can get a better idea of which one would be best for your needs.
Secured Loan
A secured loan is backed by collateral. Therefore, a borrower must back it with an asset – such as real estate owned by you or your business, office equipment, or inventory.
The lender places a lien on the collateral. If you default, the lender will seize the collateral to recover losses. The collateral you provide acts as security for the lender, enabling them to offer higher borrowing limits with lower interest rates.
Secured loans are ideal for business owners with assets needing substantial funds while benefiting from favorable loan terms.
Some examples of secured loans for businesses include:
- SBA loans: You can secure a Small Business Administration (SBA) loan, especially from the 7(a) program, with a business asset like equipment or real estate. Although the SBA guarantees a portion of this loan, you still need to back it.
- Inventory loans: Businesses needing to stock up for peak seasons can take inventory loans to purchase goods and use their inventory as collateral.
- Equipment loan: This is a small business loan secured by equipment. You take it out to purchase business equipment like vehicles, computers, and machinery. The equipment you buy is collateral, so if you default, the lender can repossess it.
- Commercial real estate loans: Commercial real estate loans allow you to purchase or renovate business property, which serves as collateral. A small business loan secured by property has longer terms and higher borrowing limits because property has significant value.
- Auto loans: You can take out an auto loan to buy vehicles for your business and secure the loan with the car you buy.
- Home equity line of credit: You can use home equity to get a secured small business loan.
Secured Loan Pros and Cons
Pros
- Often have higher borrowing limits
- Have lower interest rates compared to unsecured loans
- You can qualify for these loans even with low credit scores
Cons
- Can take time to be approved and available due to the long appraisal process for collateral
- You need an asset to secure the loan, which you can lose to lenders if you fail to repay the loan
Unsecured Loan
Unlike secured loans, unsecured loans don’t require collateral. Instead, they allow your small business to borrow based on its creditworthiness. Unsecured loans are risky for lenders as they have no assets to recover if you default.
As a result, they come with higher interest rates and limited borrowing limits. Businesses seeking unsecured loans need a perfect credit score and financial history to prove their creditworthiness. These two factors heavily influence approval and loan terms.
Unsecured small business loans are ideal for businesses without assets looking to access cash quickly.
Here are some examples of unsecured loans:
- Business credit cards: Business credit cards provide flexible access to financing for small expenses. These loans are paid monthly and can have high interest rates.
- Term loans: Term loans offer lump sums of cash with fixed monthly payments over a set period. They can be used for major expenses like inventory or expansion.
- Signature loans: If your business has a good relationship with a bank, you can get an unsecured signature loan. This type of small business loan relies on the bank’s good faith in your character and pledge to repay it.
Unsecured Loan Pros and Cons
Pros
- You don’t need collateral to access these loans
- Offer quicker access to cash as they have limited paperwork and no appraisal process
- You don’t need to risk your assets to access these loans
Cons
- Personal liability, as some lenders need a personal guarantee
- Tend to have high interest rates and low borrowing limits
- Shorter repayment terms
Some loans can be secured or unsecured depending on a lender’s terms. These include invoice financing, merchant cash advances (MCAs), business lines of credit, and working capital loans. Some lenders will ask for collateral for these loans, while others won’t.
The Key Differences Explained
Here are the key differences between secured and unsecured loans:
Collateral
One of the key differences between secured and unsecured loans is collateral. While secured loans need collateral, unsecured loans don’t. This means secured loans are ideal for businesses with assets to leverage. Usually, lenders appraise the asset and credit 80% to 90% of its value to account for potential resale challenges.
Unsecured loans don’t need collateral and are suitable for small business owners without assets to back their loans. Here are some examples of collateral that you can provide for a secured loan:
- Business assets like real estate
- Valuable personal property like cars
- Jewelry, rare paintings, watches, or other valuable collections
- Cash in the bank that the lender can seize if you fail to repay
- Financial property like stocks and bonds
Credit Score
Credit score plays a critical role in getting an unsecured role. They require a high credit score since lenders don’t have anything to leverage if you default.
In contrast, secured loans may be accessible for businesses with lower credit scores because lenders have collateral to offset the risk.
Time To Access Funds
One of the unsecured business loan pros is that it appeals to businesses needing quick access to cash. Unsecured loans typically are available a few days after approval because they have simpler application processes and less paperwork.
Secured loans, on the other hand, may be available several weeks or months after approval. These loans require asset appraisal, additional documentation, and collateral verification. This takes time, extending the approval process.
Interest Rates
Interest rate is a key consideration to make when choosing between secured and unsecured business loans. Collateral provides added security for secured loans, therefore their interest rates are lower. In contrast, unsecured loans have higher interest rates due to their lack of collateral.
Loan Terms
One of the secured business loan pros is that they offer longer repayment periods for higher borrowing limits. This is due to their low risk profile for lenders. Unsecured loans tend to have a high risk profile. Therefore, they have lower borrowing limits and shorter repayment terms.
Defaulting
If you default on a secured loan, the lender can seize collateral to recover their funds. Because unsecured loans have no collateral, lenders may need to initiate a legal process to recover their funds.
Personal Guarantee
In most cases, lenders require a personal guarantee on unsecured loans. If your business cannot repay the loan, you become responsible for the balance and can repay it with your personal assets. This adds an extra level of protection to creditors.
That said, a personal guarantee depends on the creditor’s terms; not all lenders require it. Some lenders may require a personal guarantee for secured loans.
Secured or Unsecured Business Loan: Which is Best for Your Business?
Choosing between a secured and an unsecured business loan should be informed by your business’s unique needs, goals, and financial situation. Here’s what you should consider to make the best choice.
The Amount You Need
A secured loan is the best option if you need a large amount for expansion, acquisition, or purchasing expensive equipment. This loan allows larger borrowing limits with lower interest rates, letting you access the capital you need.
Your Timeline
If you want to access funds within a few days, opt for an unsecured loan. It requires less paperwork and is available a few days after approval. However, if you can wait a few weeks or months, get a secured one to enjoy better loan terms and interest rates.
Your Credit Score
Since lenders consider a business’s creditworthiness to determine whether to give it unsecured loans, you need a perfect credit score to get this loan. Secured loans are ideal for companies with lower credit scores, as they can back the loan with assets.
Collateral Requirements
If you lack sufficient collateral or don’t want to risk your personal or business assets, an unsecured loan might be your best choice. However, you’ll pay higher interest rates.
What to Know Before Taking Out a Loan
Before committing to taking out a loan, you must understand the impact this decision will have on your business. This is what you need to know before taking a secured or unsecured small business loan.
Loan Terms
Loan terms vary widely. They impact the repayment timeline and total cost of a loan. Since secured loans offer longer terms and lower interest rates, they’re suitable for significant investments like equipment purchases.
Conversely, unsecured loans have shorter terms and larger interest rates. This makes them ideal for covering immediate, short-term needs such as managing cash flow gaps, financing inventory, or handling unexpected expenses.
Credit Impact
Small business loans can significantly impact your business credit profile. You need a strong credit score to get an unsecured loan. Therefore, a lender will assess your credit history before giving you one. If you have debt collection issues, a lender can perform a hard credit inquiry, which can lower your credit score by a few points.
Additionally, any untimely repayment can lower your credit score and signal unreliability to future lenders. Secured loans are slightly more forgiving than unsecured loans when it comes to missed payments or defaults.
The lender can seize collateral with secured loans, but the default will still damage your credit significantly. However, since unsecured loans don’t have collateral, late fees damage your credit and increase the risk of potential legal action from lenders.
Credit utilization, the percentage of available credit you use, can also affect your credit score. High balances relative to available credit can lower your score. Therefore, you should borrow amounts that you can utilize.
Loan Purpose
Consider what you need the loan for before taking out one. For instance, a small business loan for expansion is a large, long-term commitment. This means you should take out a loan with a long repayment period to remain profitable.
On the other hand, a cash influx for operational needs requires quick access to cash. Therefore, it can be achieved with short-term unsecured business loans.
Available Options
Before committing to one lender, explore various options to find the best fit for your business. Different lenders offer different interest rates, loan terms, and fees.
Create a shortlist and schedule a conversation with prospective lenders to clarify details and ask questions about your situation. This will help you understand each lender’s requirements and find the best loans with favorable terms for your business.
Conclusion
The decision between secured vs unsecured business loans comes down to your specific needs, financial health, and risk tolerance. With their lower interest rates and larger borrowing limits, secured loans are ideal for substantial investments if you have collateral available.
Meanwhile, unsecured loans offer the advantage of quick funding without needing collateral, which can be valuable if your business has a strong credit profile and immediate cash flow needs.
Whether you’re looking to fund expansion, manage cash flow, or invest in new equipment, it’s essential to weigh these factors carefully when looking at a secured vs unsecured business loan. Doing so will help you find the right fit for your business.
Need a small business loan, secured or unsecured, with favorable terms to help scale your business? Connect with E-Boost Partners today to explore secured or unsecured loan options that align with your business goals and financial strategy, helping you achieve your desired growth.
