Every small business needs money to buy products, pay employees, spend on ads, and any other investments. Some expenses are easy to pay off with existing cash flow, but it may take time to stash $10,000 away for new equipment. Likewise, it can take an entire lifetime to save enough money to afford a $5 million commercial property.
Small business loans come to the rescue and make out-of-reach investments more affordable. Understanding the difference between secured and unsecured small business loans can help you save money and increase your chances of getting approved.
What are Small Business Loans and How Do They Work?
Small business loans are a useful alternative to saving enough money before making your next purchase. Not every business owner can wait for the company to generate enough cash flow, especially startup founders. Obtaining capital from a bank, credit union, or online lender helps businesses grow and employ more people.
While these loans give small business owners plenty of upsides, financial institutions balance their risks with qualification standards and interest payments. You typically need a minimum credit score and a certain amount of revenue to qualify for a loan. Small business loans get repaid over monthly payments, and the lender adds interest which represents their return on the investment.
Is a Small Business Loan Secured or Unsecured?
A small business loan can be secured or unsecured. Some lenders offer both types of loans, while others specialize in unsecured or secured small business loans. If you get a secured loan, you can refinance it into an unsecured small business loan or vice-versa. It’s a good idea to understand the differences between these two types of loans before picking the right one for you.
The Difference Between Secured and Unsecured Small Business Loans
Business owners can use secured and unsecured business loans to raise capital for their companies. These loans can increase your cash supply and speed up your path to business investments. However, subtle differences in these loans will impact your monthly payment and how much you can borrow.
Secured small business loans require collateral if you want to receive funding. Commercial mortgages and equipment loans are two popular financial products that often require collateral. In those cases, the purchased asset becomes collateral. Some lenders let you use business assets you already own as collateral.
Unsecured loans do not require collateral, but the lender may expect a personal guarantee. If you make a personal guarantee, you are obligated to repay the loan with personal assets if business funds cannot cover the monthly payments. Not every lender requires a personal guarantee. Some lenders trust you to make payments even if you do not provide collateral or make a personal guarantee.
Other Credit Requirements
Many lenders set credit score requirements to mitigate risk. Financial institutions don’t want to get stuck with unpaid loans. You can get away with a lower credit score if you opt for a secured loan since risk shifts to the buyer. Some small business owners take out secured loans to build credit history since they are easier to obtain.
Banks set interest rates based on the implied risk of the loan. Risk is based on the borrower’s ability to repay the loan and what happens if the borrower defaults on the loan. Since the collateral for a secured loan reduces risk, borrowers end up with lower interest rates. Unfortunately, small business owners have to contend with higher interest rates if they want unsecured loans. In addition, the interest rate will be higher if your unsecured loan does not come with a personal guarantee.
Term lengths vary by lender, but secured loans typically have lengthier repayment windows. While most unsecured loans cap out at 5-year terms, it’s possible to get a secured loan with a 10-30 year term. You can refinance an unsecured loan if you need more time to make payments, but a secured loan makes monthly payments more manageable. Lenders don’t mind the lengthy terms for secured loans since collateral is tied to them.
There’s more to borrowing limits than the type of small business loan you use, but secured loans offer more flexibility. Any arrangement that decreases the lender’s risk will aid the borrower. That’s why secured loans have lower interest rates, longer terms, lower credit score requirements, and higher borrowing limits. Unsecured loans are better if you do not want to offer collateral, but you may leave funds on the table if you opt for an unsecured loan.
The Pros and Cons of Secured Small Business Loans
Secured small business loans have a lot to offer, but they aren’t for everyone. Knowing the pros and cons of this financial product and comparing them with unsecured loans can result in a better decision.
Pros of Secured Small Business Loans
- Lower credit score requirement: You can get a secured business loan with a lower credit score. Lenders shift some of the risks to borrowers by forcing them to provide collateral.
- Lower interest rate: Secured small business loans typically have lower interest rates. A lower rate can save you thousands of dollars over the loan’s lifetime.
- Higher chance of approval: You’re not guaranteed to get a small business loan. Fulfilling minimum requirements increases your chances, and a secured business loan works in your favor. You are more likely to get approved for this financial product.
- Lengthier term: A 10-year term makes a big difference for your cash flow compared to a 3-year term. Extending the loan reduces your monthly payments, which can reduce your company’s financial stress.
- Higher loan amount: You might get exactly what you need with an unsecured loan. If you need to borrow more capital, a secured small business loan can get you to the top.
Cons of Secured Small Business Loans
- You need enough assets to use as collateral: It’s easy for a commercial mortgage or an equipment loan. The acquired asset becomes collateral in these cases. However, you may have to use inventory and other assets you currently have as collateral. Not every business owner has enough resources for the collateral requirement.
- You can lose collateral: The lender can take your collateral if you do not stay on top of monthly loan payments. Luckily, you can refinance your loan or seek a longer loan term to mitigate this risk, but keep this detail in mind.
- Business experience requirement: You may have to be in business for over two years to get a secured loan. Some small business lenders have more generous experience requirements for unsecured loans.
The Pros and Cons of Unsecured Small Business Loans
The advantages and disadvantages of unsecured small business loans are the opposite of secured loans. The lists of pros and cons are below.
Pros of Unsecured Small Business Loans
- You do not need collateral: You don’t have to worry about putting company assets on the line or having enough inventory to qualify for a loan.
- More generous business experience requirement: Some small business lenders will give you capital even if you have a few months of experience. An unsecured loan may be the best path for a startup.
Cons of Unsecured Small Business Loans
- Higher interest rates: A higher interest rate increases how much you owe on the loan.
- Shorter loan terms: You may have to contend with a loan term of five years or less. That means higher monthly payments on top of a higher interest rate.
- Higher credit score requirements: Small business owners need better credit scores to get these loans. Luckily, if you have a higher credit score, you can qualify for a lower interest rate.
- Lower loan amount: You might get exactly what you need from an unsecured loan, but you will get more money with a secured loan.
- Lower chance of approval: Your chances of getting a loan improve if you seek a secured loan.
- The personal guarantee is similar to collateral: A personal guarantee is an agreement to use your personal assets to cover the loan payments if you can’t do so with business revenue.
When Should You Get a Secured Small Business Loan?
A secured small business loan makes more sense for business owners with lower credit scores who want lower interest rates. You need to have enough assets to use as collateral or use the loan’s proceeds to purchase an asset. Commercial mortgages and equipment loans are useful financial products that often use the acquired asset as collateral.
When Should You Get an Unsecured Small Business Loan?
An unsecured small business loan may be the better choice if you have less business experience and not enough assets to use as collateral. Some business owners cannot afford to lose their assets and want to avoid that risk. While these loans may have higher interest rates and higher credit score requirements, they offer a quicker path to financing.
The Process of Getting a Small Business Loan
Every bank, credit union, and online lender has an application process for their loans. It’s a good idea to shop around and compare rates from several lenders to ensure you get the best terms. It only takes a few minutes to submit basic information to get a quote.
When you choose a quote that matches your needs, the lender will do a more detailed review of your credit and request a few documents (i.e., bank statements, ID, etc.). This credit check helps a lender assess if you can make the monthly loan payments and is part of the approval process. If you get approved for the loan, the funds will appear in your bank account shortly.