Secured and unsecured loans – business.com
When you need a small business loan, one of the first decisions you need to make is whether to get a secured loan or not. Generally, secured loans are preferable for business financing because they have lower interest rates, but lenders can foreclose your assets in the event of default. Although unsecured loans do not require collateral, they are more difficult to obtain and much more expensive than secured loans. Here is what you need to know about these types of loans to determine the best option for your business.
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What is the difference between secured and unsecured loans?
The biggest difference between secured loans and unsecured loans is that secured loans require you to pledge collateral and unsecured loans do not. Unsecured loans are given only on the basis of the repayment capacity of the borrower. Therefore, if the borrower defaults, the lender can sue; However, they will not have any lien on the borrower’s property, so they cannot seize and seize property to get their money back. [Read related article: What Is a Lien?]
Because unsecured loans are not attached to any collateral, they are riskier for the lenders. This makes them more expensive and generally more difficult to obtain. However, they can also be funded faster if you qualify.
What is a secured loan?
Secured loans are what most people think of when they think of loans. These include mortgages, auto loans, equipment loans, home equity lines of credit (HELOC), recreational vehicle loans, tractor loans, boat loans – any loan made on a specific asset, which the lender can contract in the event of default by the borrower.
Since secured loans are attached to specific assets, these loans are considered less risky for the lender. After all, if you don’t pay, the lender can still get their money back by taking the asset and selling it. As a result, secured loans tend to have lower rates as well as longer repayment terms. For example, 15-year mortgage rates are currently below 3%.
Secured loans are ideal if you want long-term financing for expensive assets that you want to pay off over a long period of time. Secured loans are also generally better for people with bad credit; in fact, they are often the only option. [Read related article: Loans You Can Get With Bad Credit]
Guaranteed loan rates and conditions
- Interest rate: From around 2.8% for personal loans; 5.5% for business loans
- Borrowing limit: Up to 80% to 85% of the value of the underlying collateral
- Repayment Terms : Up to 30 years
- Sample loan: A mortgage on a house
What is non-recourse financing?
Non-recourse loans are special types of secured loans that are only secured by the underlying asset.
Most secured loans still require borrowers to sign personal guarantees. In other words, if you default, the lender can take your property and sell it to try to get their money back – and sue you for the difference if your property isn’t earning enough to pay off the loan.
This is not the case with non-recourse financing. The lender has no recourse beyond foreclosure if you default.
These loans are only used in certain circumstances, most often for large real estate acquisitions by established investment groups. Loan amounts are usually large, as are down payments. The terms can also be quite long (30 years or more) and the rates are relatively low. Also, many of these loans come with prepayment penalties, so you will have to pay more if you want to prepay the loan. Essentially, these are niche loan products that are usually only available to large, sophisticated companies, but they are great if you can get them.
What is an unsecured loan?
An unsecured loan is debt that is not secured by an underlying asset. The approval of these loans is based solely on the creditworthiness of the borrower, and they usually involve heavy personal guarantees anyone who owns more than 20% of the business.
Unsecured loans are generally more expensive than secured loans and also have shorter repayment terms as they present greater risks to the lender. This makes unsecured debt better for those who need short-term financing that they can access quickly and pay off in a relatively short period of time (think months rather than years).
However, these loans are only an option if you qualify. The minimum credit scores to qualify are generally 40 to 60 points higher than the minimums for secured loans; most unsecured loans are not even available if you have bad credit.
Rates and terms of unsecured loans
- Interest rate: Start around 6%
- Borrowing limit: Varies according to income; Typically, total debt service (along with other debt) cannot exceed around 36% of your income
- Repayment Terms : Usually up to five years
- Sample loan: A business credit card
Common types of secured and unsecured loans
Here are some examples of different types of secured and unsecured loans.
- A mortgage: Almost all home loans are secured by the house itself.
- A car loan: Whether you buy a new or used vehicle, to get a car loan, you must give the lender a lien on your vehicle, so that they can repossess it in the event of default.
- A loan of equipment: As with auto loans, lenders who finance pieces of equipment generally place a lien on that equipment.
- A secured credit card: If you don’t have established credit and need to start with a secure credit card, you will need to deposit cash that you can borrow against to use your card.
- An unsecured credit card: Borrowers with established credit can usually get credit cards without first depositing cash.
- A signature line of credit: Some banks and other lenders offer lines of credit based solely on the borrower’s ability to repay, with no underlying collateral.
- A consolidation loan: Loans used for consolidate other business debts are not actually secured by the underlying assets.
- A student loan: Federal student loans can’t be discharged in bankruptcy, but they’re also not tied to specific assets the government can take if you don’t pay.
Secured or unsecured loan applications
When you apply for an unsecured business loan, the underwriting process is usually fairly straightforward. A lender will examine your tax returns, income statement, credit report, and bank statements to measure your free cash flow. They will also make sure that you have good credit and will be able to cover the cost of the loan. If you meet these criteria, the lender will approve and fund the loan.
The process of taking out secured loans can be a bit more complicated. This is because the lender must assess not only the borrower, but also the underlying collateral. In other words, the lender will want to consider everything that would be required for an unsecured loan as well as the condition and value of your collateral. This usually means ordering an assessment and possibly an inspection. If the loan is for a business asset such as a piece of equipment, the lender may also need to conduct lien research to ensure that no other lender has a claim against that asset.
Advantages and disadvantages of secured loans
A secured loan is usually best if your business is just starting out or if you don’t have good credit; in fact, it may be your only option. Secured loans are also generally better because they allow you to lock in lower rates than those available with secured financing. Finally, if you want to pay off your loan over three to five years, a secured loan is usually the way to go.
- Lenders offer lower rates.
- Longer terms are generally available.
- Underwriting is more complicated because the lender has to assess your collateral.
- The lender can seize the underlying asset if you default.
- You will probably still have to sign a personal guarantee.
Advantages and disadvantages of unsecured loans
An unsecured loan is usually only an option if your business is well established and generates consistent income. If this is the case and you need to access funds quickly, an unsecured loan may be your best option, especially if you have enough cash to pay off the loan in a short period of time.
- Loans can be funded much faster.
- You don’t have to worry about a lender having your assets foreclosed.
- You can still be sued for non-payment of the loan.
- Loans generally have higher rates and shorter terms.
Whether you need to get a secured or unsecured loan depends on what you may be eligible for and the specifics of your business financing needs. While secured loans offer lower rates and longer terms, unsecured loans offer quick financing and do not come with a threat of foreclosure. If you have established liquidity and excellent credit and need funds quickly, an unsecured loan may be ideal. If you are still building your credit or already have a lot of outstanding loans, a secured loan may be your best bet.