Can a Small Business Loan Be Secured or Unsecured?

Can a small business loan be secured or unsecured?

This is somewhat of a tricky question. The main point of differentiation is whether the loan requires collateral. In other words, will you pledge an asset to the lender? If yes, then this is called a secured loan. If not, then this is an unsecured loan.

That one distinction changes every aspect of the loan, from the interest rate you'll pay to how long you'll have to repay the loan to how large the initial loan amount will be. Secured loans, lines of credit, and merchant cash advances all follow these guidelines.

Below, I've outlined how each compares, the criteria lenders typically consider, and how you can determine which type of loan best fits your business.

What Is a Secured Business Loan?

A secured business loan is secured by collateral. The collateral is an asset that you're pledging to the lender. If you fail to make the loan payments, the lender can take the collateral and sell it to recover any losses.

Common types of collateral used for securing business loans fall into two categories:

Business assets

Personal assets

Commercial real estate

Home or car

Vehicles

Stocks and bonds

Equipment

Other financial assets

Accounts receivable

Valuable jewelry or collectibles

Inventory

Other valuable items

Once you've taken out a secured loan, you're granting the lender a legitimate claim to whatever collateral you've agreed upon. Having that claim in place protects the lender from loss in case you can't make your payments.

Since there is reduced risk for the lender, a secured loan generally includes lower interest rates and longer repayment periods for the borrower than an unsecured loan. Business owners often use secured loans to purchase inventory, create employment opportunities, buy new equipment, or expand operations.

Types of Secured Loans

Secured business loans are offered by banks, credit unions, and online lenders. Most commonly, secured business loans are categorized under:

• SBA loans, backed by the U.S. Small Business Administration

• Factoring of invoices

• Lines of credit for businesses

• Financing for equipment

Regardless of which category a secured business loan falls into, lenders will always review your business's revenue prior to approving it. One exception to this rule is a HELOC.

How Does a Home Equity Line of Credit (HELOC) Work?

While most other financing options reviewed in this section rely on your business's revenue for approval, a home equity line of credit (HELOC) allows you to draw funds against the equity in your home.

Unlike all other types of financing reviewed here, a HELOC has one major benefit: qualifying for it is not dependent on your business's revenue. So newer businesses, and those with lower revenues, can qualify for a HELOC as long as you have enough equity in your home.

However, unlike secured business loans, you are putting your home at risk by using it as collateral. If you can't repay the loan, the lender has the right to foreclose on your home. So while a HELOC can open doors that business-revenue lending can't, it places a personal asset at risk. Before applying for a HELOC, discuss your options with a lending advisor.

What Is an Unsecured Business Loan?

An unsecured business loan is a form of financing that doesn't require you to pledge an asset. Since the lender is taking on more risk by providing financing without requiring collateral, unsecured business loans typically carry higher interest rates and shorter repayment periods than their secured counterparts. Banks and online lenders both offer unsecured business loans.

Lenders will evaluate your eligibility for an unsecured business loan primarily on:

• Your business credit score

• Your time in business

• Annual or monthly gross revenue

Although an unsecured business loan may not require collateral, a lender may still ask you to provide a personal guarantee or a Uniform Commercial Code (UCC) lien to lower its exposure. By signing a personal guarantee, you are committing to repay any outstanding debt should your business be unable to. This also means the lender can pursue your personal assets to recoup any remaining debt.

Types of Unsecured Loans

There are several types of unsecured loans available. You've likely encountered several already:

• Business credit cards issued by banks

• Student loans (federal, private, or both)

• Personal loans and medical loans

Lenders may also file liens against specific collateral or issue blanket liens. A blanket lien lets the lender claim ownership of all business assets should you default. So always read the fine print and understand all the terms in your loan agreement before accepting it.

When Do Personal Guarantees Still Place Your Assets at Risk?

Although an unsecured business loan does not involve collateral, a lender may still ask for a personal guarantee. This means you are personally accountable for paying off any outstanding debts your business incurs if it defaults. Even though you didn't pledge any collateral, the lender can pursue your personal assets, like your house or savings, to satisfy any remaining debt. These conditions are clearly defined in your loan agreement, so read it carefully before signing.

Unsecured vs. Secured Loans

Secured loans share the same advantages and disadvantages as most financing options.

Here are the advantages and trade-offs of unsecured loans:

What Type of Small Business Loan Should You Choose?

Choosing the right type of small business loan will depend on how well you align with what lenders want. I recommend using the following points as guidance when you're deciding which type best fits your needs.

• Loan terms. First, know how much you need and how much your business can afford to pay back. Prepare your business plan, balance sheet, and proof of your business history before you research lenders and compare terms like the total dollar amount borrowed (loan amount), interest rate charged, and length of repayment period between secured and unsecured small business loans.

• Assets available for collateral. The next thing to consider is the assets available to act as collateral. If you have acceptable assets to pledge and you're willing to use them as collateral, then a secured loan would probably be suitable. On the other hand, if you're a relatively new business without assets to pledge, but you have strong personal credit and stable cash flow, then an unsecured loan may be more advantageous.

• Speed to funding. Finally, speed is important. Secured loans tend to take longer to finalize, since lenders must evaluate and potentially appraise any proposed collateral before making a final decision, and there will be more paperwork involved. If you need immediate cash to fund working capital, an unsecured short-term loan can provide the funds you need sooner.

Examples of When To Choose an Unsecured or Secured Loan

Each situation presents unique considerations. Here are two scenarios to show how choosing between unsecured and secured may play out for different businesses.

Established construction company needs new equipment

Construction companies rely heavily on equipment for their daily operations. A construction company looking to replace aging equipment might opt for secured equipment financing, where the equipment being replaced serves as the collateral.

A retail store facing seasonal cash flow gaps

Retailers with seasonal swings, like the holiday season, face challenges keeping cash flow steady during peak sales. Rather than buying more inventory or adding staff, they use an unsecured line of credit to fill the temporary gaps.

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FAQs on Secured and Unsecured Loans

Here are some of the most common questions that I hear about these types of financing.