Many business owners borrow money from lenders to make investments and cover operating expenses. Receiving capital helps companies grow faster or acquire inventory before a busy season. Business owners can choose between secured and unsecured loans.
Most lenders require business owners to pledge collateral to secure a loan. If your business doesn’t have enough assets to back up the loan, you may be forced to use your personal assets. However, risking your car or house may not be the best solution. Some borrowers do not want to incur that type of risk. Luckily, you can tap into unsecured business loans to finance your business needs.
In this post, we’ll discuss unsecured business loans, how they differ from secured loans, the pros and cons, and the available options. You’ll also learn what you need to qualify for an unsecured loan and where to get one.
What is an Unsecured Business Loan?
An unsecured business loan is a loan that doesn’t require any form of collateral like equipment, inventory, or real estate to secure funding. This arrangement reduces a borrower’s risk and still gives them access to capital. It can be especially helpful for borrowers starting out who don’t have as many assets. Lenders often issue this type of loan using the borrower’s creditworthiness rather than collateral.
However, some lenders may still require a personal guarantee or a UCC lien. When you sign a personal guarantee, you agree to use your personal assets as collateral. It effectively pops the corporate bubble if you have your business set up as an LLC or similar entity. A UCC lien gives the lender the right to seize your business assets if you can’t repay the loan.
Typically, getting approved for an unsecured loan is more difficult than getting a secured loan because lenders rely on your creditworthiness. You might also get stuck with a higher interest rate because the lender takes on more risk. But if you have a strong credit history and a steady income stream, you should have an easier time qualifying for an unsecured loan. In addition, an excellent credit score can help you get lower rates even if you use an unsecured business loan.
How Is an Unsecured Business Loan Different from a Secured One?
Secured and unsecured loans both let you get more funds, but it’s important to know the differences. As mentioned before, unsecured business loans allow you to borrow money without having to pledge collateral. On the other hand, secured business loans require you to put up collateral to get the funding. If your business is unable to repay the loan, the lender will seize your valuable assets to recoup the losses. Generally speaking, secured business loans are riskier than no-collateral loans because you have something to lose if you default.
Another difference is that lenders are more willing to give out secured loans because of the collateral pledged as “security.” Plus, you may qualify for larger amounts than you would if you apply for unsecured business financing.
Pros of Unsecured Business Loans
Tapping into unsecured small business loans has several benefits, including:
Quicker Access to Cash
Unlike secured loans, such as SBA loans that take a month or longer, unsecured financing has a short approval process. This means you can access the funding you need faster to cover your business expenses. For example, some businesses need cash urgently to pay for a bill that’s due in a week.
Shorter Process and Approval
Since unsecured business funding doesn’t require collateral, lenders do not need an appraisal as part of the application process. This translates to a faster application and approval process compared to secured financing options. As a result, you don’t need as much paperwork and can use your extra time to work on your business.
No Collateral Needed
Unlike other forms of business financing, you don’t need to pledge collateral to qualify for an unsecured business loan. This makes unsecured loans the best financing option for startups and small business owners with insufficient physical assets to back up the loan.
No Risk of Collateral Loss
Because you don’t need to put up any form of collateral, there’s no risk of losing physical assets if your business cannot repay the loan. You should still make it a point to make on-time loan payments since falling behind will hurt your credit score and result in accumulating interest. Only take out a loan if you can afford the monthly payments. With that said, it can take some weight off your shoulders if you don’t have any collateral tied to the loan.
Cons of Unsecured Business Loans
As with any other form of business financing, unsecured business loans have drawbacks.
Higher Interest Rates
Since unsecured business loans do not require collateral, they typically come with high interest rates. That’s because risk shifts from the borrower to the lender. Financial institutions will set higher interest rates to compensate for this imbalance. Higher interest payments give them a buffer in case borrowers default on their loans.
Smaller Loan Amounts
Unsecured small business loans present more risk to lenders because they don’t have anything to seize if a borrower defaults on monthly payments. For this reason, they offer smaller loan amounts than collateral loans. You may qualify for higher loan amounts if you have a good credit score and earn a lot of revenue for your business.
Harder to Qualify For
Unsecured loans aren’t for everyone. Due to the risk posed by unsecured loans, lenders put in place strict eligibility requirements. Unfortunately, this means it can be hard to qualify for, especially if your business has a bad credit score, unreliable income stream, or low debt-to-income ratio. Check the requirements before applying for an unsecured loan. Some business owners will benefit from seeking secured business loans due to the easier requirements.
Personal Guarantee
Some lenders may require a personal guarantee, meaning you may be forced to repay the loan using your personal assets if the business revenue and assets cannot cover the loan payments. While these loans don’t have collateral, a personal guarantee can put your assets at risk, just like a loan with collateral. However, you might get a lower interest rate for offering a personal guarantee or access to better terms.
Defaulting on Your Loan Can Damage Your Credit
If you default on unsecured funding, your credit score can take a major hit. This may lower your financing options and approval odds for future loan applications, even secured business loans. Loan defaults stay on your credit score for six years, and you’re still on the hook for the debt. In fact, it can accumulate rapidly due to fees and interest.
Common Types of Unsecured Loans
There are different types of unsecured business loans, each with pros and cons—understanding how each financial product works will help you decide on a good option for your business needs.
Term Loans
Term loans are a financing option that provides borrowers with a lump sum amount of money, repaid over a set period of time at regular intervals. This type of unsecured loan is ideal for business owners needing a lump sum amount of cash. These loans typically offer more capital than the other choices, but you may also have to contend with a higher credit score requirement.
The interest rate, capital, and years on the loan impact your monthly payments. Borrowing more capital and selecting shorter loans will increase how much you owe. Some business owners use long-term loans and stretch the payments over more years to prioritize cash flow. Each extra year you add on the backend of the loan spreads out the lump sum over additional monthly payments.
Most term loans use a fixed interest rate, which makes the payments more predictable. However, you can also get a variable-rate loan. This interest rate fluctuates based on the market, making your monthly payment less predictable. Because of this extra risk, variable-rate loans initially have lower interest rates than fixed-rate loans. You can also refinance one of these loans later to secure a lower interest rate, take out more cash, or spread the same principal over more years to lower your monthly payments.
Business Line of Credit
Unlike term loans that give you access to a lump sum at a go, business lines of credit allow you to access cash on an as-needed basis up to a predetermined amount. With a business line of credit, you’ll only need to pay interest on what you draw and borrow again once you pay it off. As a result, business lines of credit are a suitable funding solution for businesses that require quick access to funds for recurring expenses.
Unlike installment loans, most business lines of credit have variable interest rates. The same rule applies to business credit cards, another type of credit line. You will be in good standing if you make the minimum monthly payment, but interest will accumulate during the draw period. Once the draw period concludes, the remaining balance on your business line of credit will convert into an installment loan. You can make daily or weekly payments on your business line of credit during the draw period to reduce how much you pay each month if you have any remaining balance. Business lines of credit usually feature higher interest rates and lower principals than installment loans.
Merchant Cash Advance
A merchant cash advance (MCA) allows you to borrow a lump sum of cash against your future business sales. The funds from an MCA aren’t considered a loan but rather a cash advance based on the volume of credit card receipts. MCAs are ideal for businesses that require fast cash and have a huge volume of credit card sales, but they aren’t the best option. Interest rates can vary considerably, and some business owners get stuck with APRs over 100%. Nevertheless, merchant cash advances still attract business owners because of the quick access to cash and low credit score requirements. Business owners who cannot get installment loans or lines of credit because of their credit reports may seek out this type of financing instead.
Invoice Factoring
Invoice factoring lets you sell your outstanding invoices at a discount to an invoice factoring company and, in exchange, get a lump sum of money. The factoring company is responsible for collecting the payments, usually in 30 to 90 days. This method saves you time since you no longer have to collect invoices and reach out to customers. Invoice factoring is one of the few strategies that provide more capital but does not increase your financial obligations. Once you sell your invoices, you can walk away without having another monthly payment in your budget.
How Do You Typically Qualify for an Unsecured Business Loan?
The requirements for an unsecured business loan vary depending on the lender. Generally, here’s what most lenders require when evaluating your eligibility.
- Good credit score
- Established repayment history
- Low debt-to-income (DTI) ratio
- Strong business revenue
As mentioned before, qualifying for a no-collateral loan is difficult, especially if you’re applying through a bank. However, it may be easier to get approved for an unsecured loan when you consider alternative options like online lenders.
