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What is the Difference Between a Secured and Unsecured Loan?

What is the Difference Between a Secured and Unsecured Loan?

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What is the Difference Between a Secured and Unsecured Loan?

Whether you’re looking to cover working capital requirements or invest in new property, plant, and equipment, making the right choice between secured and unsecured business loans will have financial consequences on your business. 

Key Differences between Secured and Unsecured Business Loans

When applying for a small business loan, you’ll have the choice between two basic loan types: secured and unsecured. 

Secured loans require the debtor to pledge assets, also known as collateral, to act as a guarantee to the bank in the event that the debtor can no longer afford their payments. 

An unsecured loan, on the other hand, does not require the debtor to pledge collateral. Instead, the lender takes on additional risk since it does not have access to assets that it can seize in the event of a default. 

While collateral constitutes the main difference between these two types of loans, there exist some key differences beyond that, including differences in eligibility requirements, interest rates, and SBA guidelines. Your personal creditworthiness may play a role in the loan application process.

Related: What to know about collateral for small business loans

Secured Loans for Small Businesses

With a secured small business loan, you will pledge collateral to the bank as a way to mitigate the bank’s risk. While the pledging of collateral acts as a source of risk for the debtor, it can also lead to lower interest rates in some cases.

Collateral and Interest Rates

The relationship between collateral and interest rates revolves around the risk the bank assumes by extending credit backed by business assets. 

One bank we surveyed while writing this article advertised secured business loans with interest rates as low as 3.99%. On the other hand, that same bank advertised unsecured term loans with interest rates of 4.75%, a 0.75% difference. 

However, interest rate calculations have additional complexities beyond the presence of collateral. Your specific lender will choose an interest rate based on debt market conditions, the federal funds rate, and the lender’s unique underwriting requirements. 

Secured Loan Eligibility

Lenders will typically have their own criteria of eligibility for small business clients. One bank we surveyed required that small business owners have operated for two years and had a minimum of $250,000 in annual revenue for a secured term loan.

A certain amount of personal assets may also act as another requirement for these loans.

Secured SBA Loans

For Small Business Administration (SBA) loans, lenders will have additional requirements to fulfill to receive underwriting approval. The basic eligibility requirements for secured SBA loans include:

  • The borrower must run a for-profit business in the United States.
  • The owner must have invested their own equity in the business.
  • The business owner has utilized all other financing options.

The types of secured SBA loans include various 7(a) loans. These loans do not have SBA collateral requirements up to $25,000, though lenders may impose their own requirements as a condition for underwriting the loan. 

Unsecured Loans for Small Businesses

Unsecured loans do not require debtors to pledge collateral as security for the lender. Instead, the lender makes the loan with the promise that the debtor will pay the loan back on time and in full. 

The most common types of unsecured business loans include: 

  • Unsecured Lines of Credit: A business line of credit, also known as a revolver, acts similar to a credit card for a business. A business will receive a maximum line amount which it can access any time in exchange for monthly payments. This type of loan most commonly helps businesses to pay for working capital. This helps to smooth out cash flow month-to-month.
  • Unsecured Term Loans: Through an unsecured term loan, the lender pays the debtor a lump sum in exchange for fixed payments over the lifespan of the loan. This type of loan helps businesses to make large, one-time purchases. 
  • SBA Loans: The 7(a) loan program offered by the SBA does not have collateral requirements up to $25,000, though lenders may have their own collateral requirements.

Interest Rates for Unsecured Small Business Loans

Since unsecured loans do not have collateral requirements, lenders typically institute higher interest rates to accommodate the increased risk they take by extending this type of credit. 

From banks we surveyed, we found that interest rates were most typically around 30% to 40% higher than secured loan interest rates.

Unsecured Loan Eligibility

Since unsecured loans typically have shorter lifespans (or indefinite ones in the case of lines of credit) and smaller principal amounts, banks will usually have lower requirements for eligibility with respect to time in business and annual revenue. 

While it is possible, it’s worth noting that getting an unsecured loan for a new business is very unlikely. 

Unsecured SBA Loans

As with secured SBA loans, unsecured SBA loans will have all the same common types of SBA requirements in addition to any other underwriting rules the lender has for this type of debt. 

Deciding Which Loan Type is Right for Your Business

Ultimately, there exist many types of loans that may or may not be suitable for your business. Here are several different types of loans and their corresponding uses:

  • Lines of Credit: As stated previously, a line of credit works best for working capital purchases that your business must make frequently, such as inventory. You will make repayments regularly, usually on a monthly basis. 
  • Term Loans: A term loan makes sense when your business needs a large amount of additional capital upfront for large, one-time projects.
  • Commercial Real Estate Loans: If you plan to invest in commercial real estate, a commercial real estate loan can provide the capital you need.
  • Equipment Loans: For new equipment or infrastructure, an equipment loan can help your business make the purchase without dipping into retained earnings. 
  • Healthcare-Specific Loans: If you operate a healthcare practice, many lenders offer healthcare-specific loans to help start or grow your practice. 
  • Secured Loans: A secured loan can help to refinance existing debt or expand your business. In some cases, you may need to provide a personal guarantee based on your credit history. 
  • SBA Loans: Lastly, an SBA loan makes the most sense when you’ve exhausted other business financing options. Various programs can help you to take the next step in your business, including 7(a) SBA loans and 504 loans. The exact requirements depend on the loan amount. 
  • Alternative Financing: Other types of financing include business credit cards, revolving loan funds, alternative lenders such as online private lenders, merchant cash advances, and the many startups offering unique forms of credit.

Next Steps in Getting a Small Business Loan

After you have decided which business loan makes the most sense for your next project, you’ll want to better understand your personal credit score as well as your business credit score (FICO SBSS) to determine if you meet the minimum eligibility requirements.

What is the Difference Between a Secured and Unsecured Loan?

What is the Difference Between a Secured and Unsecured Loan?

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