Starting — or growing — a business is a big undertaking, and obtaining the right financing can make or break its success.
There are two main types of business loans available: secured and unsecured. Knowing the difference between the two and which one is best for your business is crucial to securing the financing you need to achieve your goals.
So how do you know which one is right for you?
Keep reading to find out the difference between secured and unsecured business loans, the pros and cons of each, and how to get a loan once you’ve decided which kind you need.
What’s the Difference Between Secured and Unsecured Business Loans?
Secured and unsecured business loans are two different types of financing options available to entrepreneurs.
The main difference between the two is the level of risk for the lender. Secured business loans are less risky for the lender because they get something from the borrower in the event of default. This makes that type of loan easier to get.
Unsecured business loans are considered to be a higher risk for the lender. Because of this, they are often more difficult to obtain.
Let’s take a look at the differences between secured and unsecured business loans concerning:
- Collateral requirements
- Personal guarantees
- Credit score; and
- Interest rates
A secured loan requires collateral. That means the business taking out the loan has to provide something as a guarantee that can be seized by the lender if payments aren’t made.
Examples of collateral are business assets like:
- Inventory; and
An unsecured loan does not require collateral from the borrower.
Unsecured business loans may require a personal guarantee. This means that the person applying for the loan promises they will repay using their own assets if the business is unable to do it.
A secured business loan does not require a personal guarantee because the borrower has offered up collateral instead.
Lenders conduct credit checks for all businesses applying for loans. But for secured loans, banks are usually more lenient about credit requirements. There’s a little wiggle room because lenders know they’ll still get something in return if the loan isn’t fully repaid.
With unsecured loans, the standards are higher. Since the bank doesn’t have a guarantee that the loan will be repaid, they generally have stricter requirements for the borrower’s credit score.
An unsecured loan credit check may look at your:
- Personal credit
- Business credit; or
Since secured business loans are less risky, they usually offer lower interest rates. They often have other favorable terms like higher borrowing limits and longer repayment periods.
Since unsecured business loans aren't guaranteed, their interest rates are typically higher.
Common Types of Secured Business Loans
Common types of secured business loans include:
- SBA 7(a) loan — A government-guaranteed loan program offered through the Small Business Administration
- Equipment financing — Used to purchase equipment for a business
- Commercial real estate loan — Used to purchase or finance commercial property
- Invoice financing — Used to borrow against outstanding invoices or accounts receivable
- Lines of credit — A flexible loan option that allows a business to draw funds as needed
- Merchant cash advance — A loan that is paid back through a percentage of future credit card sales
- Agricultural loan — Used for buying farmland, livestock, or equipment
Common Types of Unsecured Business Loans
Common types of unsecured business loans include:
- Business credit cards — A line of credit extended to a business, typically with a personal guarantee from the owner
- Personal loans for business — A loan taken out by a business owner using their personal credit and assets
- Short-term loans — A loan with a repayment term of less than a year, usually used for working capital or emergency funding
- Peer-to-peer (P2P) loans — Funded by individual investors and facilitated by online platforms
- Microloans — Loans that are usually under $50,000 and provided by non-profit organizations or government agencies
- Invoice factoring — A financing option that advances payment on outstanding invoices in exchange for a fee
Is It Better To Get a Secured or Unsecured Loan?
When making financial management decisions for your organization, you may need to look at a variety of factors when deciding if a secured or unsecured business loan is best. These include how good your credit rating is, the type of collateral you have to offer, and which kind of loan you want.
Ultimately, the decision between a secured or unsecured business loan will depend on the needs of your business and your personal financial situation.
Both secured and unsecured business loans have their pros and cons, so it’s essential to understand the differences before making a decision.
Advantages of Secured Business Loans
There are many advantages of secured business loans, including:
- Lower interest rates and more favorable terms
- The opportunity to borrow larger amounts of money; and
- A clear definition of seizable assets
Perhaps one of the biggest advantages of a secured business loan is that it’s easier to obtain than an unsecured loan.
Disadvantages of Secured Business Loans
One of the disadvantages of a secured business loan is that not every business — especially if it’s small — has collateral to put against the loan.
And if you do have assets to put up, you risk losing them if you aren’t able to repay the loan.
Advantages of Unsecured Business Loans
The biggest advantage of an unsecured business loan is that the lender does not have to provide collateral as insurance for nonpayment. These loans may also be available to small business owners who would have trouble qualifying for a secured loan.
Disadvantages of Unsecured Business Loans
An unsecured business loan comes with more disadvantages. These include:
- Higher interest rates and less favorable repayment terms
- Lower borrowing limits
- More paperwork to fill out; and
- Better personal credit history required
If you’ve given a personal guarantee for the loan, there’s also a risk that your personal assets will be seized if you default on payments.
How Do I Get a Business Loan, Secured or Unsecured?
There are similar processes for getting secured vs. unsecured business loans, but the differences are important. Either way, your lending agency will check your credit rating.
The minimum credit score required for business loans varies, but some require at least a 580 — and many necessitate an ever higher score.
Here are a few steps to follow when figuring out the type of loan you need and going through the process to get it.
Establish the Purpose of the Loan and How Much Money You Need
First, you must decide why you need the loan and how you want to use it. Lenders don’t just hand out money — they’re looking for a good reason to give it.
For instance, lenders are more likely to grant you a loan if you’re planning to use the money to do something like expanding your business or upgrading your technology. But if you want the loan to pay off financing for other purchases or to buy non-essential business assets, they may not be as inclined to lend funds.
When deciding how much money to ask for, there’s a sweet spot. Many banks don’t lend small amounts, and if you ask for too little you may not be able to accomplish everything you wanted to do with the funds.
But if you ask for too much money, lenders will probably doubt your ability to repay and deny the loan.
Choose a Lender
Figure out which type of lender will be best for your needs. It could be:
- A bank
- A non-bank lender
- Alternative investment sites; or
Each has its advantages and disadvantages, so do your research and figure out what might work best for your business.
Fill Out Paperwork and Provide Necessary Documentation
Once you’ve decided which lender to go with, get a loan application package from them and start knocking out the requirements. It’s smart to provide some data showing you’ve done your research and are worthy of this loan.
You may want to include your:
- Profit and loss statements
- Cash flow statements
- Balance sheets
- Business plan with a budget; and
- Personal financial information with three years’ tax returns
If you meet the necessary requirements, your loan will be granted and you can use the funds to help your business flourish.