Every day, entrepreneurs dream of better ways to do things. However, considerable sums of money often stand between them and their vision.
To get started, they approach banks and other financial institutions for funding. Secured and unsecured loans are most common financial instruments offered to them.
What is the difference and which is better? We’ll explore these questions and other concerns in this extensive guide.
What is loan security, and why do businesses need to provide it?
Every time a lender loans money, they take on considerable risk. The amount they earn via interest payments can be quickly wiped out if too many borrowers default on their debts.
To avoid this disastrous scenario, a financial institution will require a form of collateral from the borrower. Usually, the deed to a property or a car title is deemed to be a sufficient loan security.
If the borrowing entity defaults, the lender can take possession of the asset and liquidate it to cover the loss caused by the bad loan. These arrangements are typically known as secured loans.
What is an unsecured loan?
An unsecured loan is a financial arrangement where a lender provides a borrower with capital based on their trustworthiness. This is assessed by their credit score, which is determined by their credit utilization, payment history, and other factors.
A borrower with a high credit score can get more attractive terms, while those with a lower score are charged higher interest rates and can have the size of their loan restricted.
With no collateral to protect lenders, unsecured loans are riskier ventures than secured loans. However, there are a number of mechanisms which can help them recover capital if a borrower defaults.
A lender can sell a bad debt to a collection agency for a percentage of the balance owing. These companies will then contact the delinquent borrower to recover what is now owed to them.
Alternatively, financial institutions can opt to take a borrower to court. If a decision is rendered in the lender’s favour, the defaulting party’s wages can be garnished, a lien can be placed on their assets (allowing them to be seized), or a repayment plan can be crafted.
What are the pros & cons of secured and unsecured loans?
As a business owner, both secured and unsecured loans may be offered to a business owner. Which is best? It depends on their situation – below, we’ll discuss the pros and cons of both types of loans.
PRO: They can be used to acquire large sums of money
Lending is a trust business. If a business is able to provide a financial institution with an asset of considerable value, they are much more likely to supply it with a sizable loan.
The confidence that collateral provides makes this possible – if the borrower defaults, they are guaranteed to get at least part of their money back.
PRO: They offer lower interest rates
Secured loans are a lower risk arrangement for lenders. As a result, they are able to offer a lower interest rate to borrowers.
This reduces the entrepreneur’s burn rate, making it easier for them to grow their business and pay back the loan faster.
CON: Stakes are high for the borrower
Nobody knows what the future will bring. If a sudden downturn in the economy leaves a borrower insolvent, the lender has the right to seize whatever asset they had put up as collateral.
CON: No significant assets, no secured loan
Many first-time entrepreneurs lack significant assets. They lack assets, or the ones they do own (e.g. a used car) are ones that no loan manager would ever accept for a sizable secured loan. As a result, borrowers in these situations are unable to obtain this type of financing.
PRO: Unsecured loans are easily accessible
Unless a borrower’s credit is exceptionally bad (or if they have no credit history), most are able to qualify for an unsecured loan. Proof of income and sufficient savings is usually all that is needed for approval by lenders.
PRO: The consequences of a default are less severe
Even responsible borrowers can end up in arrears. An unexpected health issue, the rejection of a substantial insurance claim, or an economic downturn can leave a debtor unable to pay their bills.
If a business owner is on the hook for an unsecured loan, though, they might not have to worry about losing their house. While alternative payment arrangements will have to be negotiated, being in default on an unsecured loan is a less dire situation for the borrower.
CON: Loan amounts are smaller
Unsecured loans are a higher risk arrangement for lenders. As such, the maximum sum they will be willing to lend will be lower compared to the maximum for a secured loan.
CON: Interest rates will be higher
To overcome the elevated risk of an unsecured loan, higher interest rates are charged on the balance owed. This translates into higher payments for borrowers – this makes it harder for them to grow their business and to pay back the loan quickly.
What are some other financing alternatives?
Those unable to get an unsecured loan have additional financing options at their disposal. These include:
- Cash advances – if they need money to fill the gap between the issuance and the reception of payment for an invoice, there are businesses which provide loans for this purpose. BlueVine’s cash advance solution is a prime example of such a company.
- Peer to peer loans – A poor credit score can make it difficult for an affected entity to borrow money. Applying for a peer-to-peer loan may be the best solution for them, as many services lend regardless of one’s standing. As a consequence, interest rates can be very high, though.
- Government grants – Their availability varies widely by region. However, if an applicant business is able to meet its requirements, they can acquire funding with no financial strings attached.
- Crowdfunding – Sites like Kickstarter allow entrepreneurs to download the risk of a startup to contributors from across the internet. However, they must hit a funding target before they can access any donated capital.