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What is Secured and Unsecured Business Loan?

There are two basic types of bank loans that every business owner should be familiar with before signing on the dotted line: secured and unsecured loans.

Whether you are working with an SBA lender or any other type of lending institution, it is important to understand the difference between secured vs unsecured loans. Generally speaking, this difference will affect the risks you hold as a borrower and will often directly influence the terms of the loans themselves. By taking the time to learn more about how various loans are structured, it will be much easier to determine the best loan options for you.

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What is a Secured Loan?

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Secured loans are loans that are backed up with some form of collateral. Collateral is something pledged as “security” for repayment of a loan. In the event that you cannot repay your loan, you may lose the collateral. Inherently, this makes the loans structurally riskier than no collateral loans because you physically have something to lose.

Collateral for a secured loan can take the form of the item you are purchasing, such as your property or your business-related equipment. It’s similar to when you take out a loan to buy a house, the bank (or finance company) will keep the deed to your home until you repay the loan, including interest and any fees. If you are not able to make your payments, the bank can put a lien on your house. In many cases, this creates a situation in which you can access significantly more capital. For example, while you might only be able to qualify for a $10,000 loan from your bank, you still could very well qualify for a $200,000 mortgage (or more). Other assets can also serve as collateral to secure a loan, including personal property, even stocks and bonds.

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Often, a home serves as a reliable form of collateral because banks understand that people will generally do whatever is necessary to maintain their home. This doesn’t always hold true, however, as the subprime mortgages underlying the Global Financial Collapse demonstrated just more than a decade ago. But again, the idea behind a secured loan is that the asset the borrower is putting up as collateral is something of value that the person will work hard to prevent from losing to the bank.

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What is an unsecured business loan?

The biggest difference between secured and unsecured business loans is that the latter doesn’t require the borrower to provide any collateral against the amount they’re borrowing. In fact, Jeff Fazio, head of small business specialists at TD Bank, said that type of loan is “strictly backed by the borrower’s creditworthiness.”

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“Small businesses typically seek an unsecured loan when they either cannot qualify for a traditional loan or can’t negotiate better repayment terms with another lender,” Fazio said. “The personal guarantee terms that are outlined within unsecured loans can be very generous for borrowers, but any default can have long-term ramifications that outweigh benefits like negative effects to your business’s credit score.”

Because an unsecured business loan is better for the borrower, the lender generally charges much higher interest rates than they would for a loan backed by collateral. This kind of loan is also much harder to obtain as a result. The inherent risk involved in an unsecured business loan naturally means it will generally be offered as a short-term loan to alleviate the lender’s risk.

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To qualify for an unsecured business loan, Fazio says, your small business needs to be able to “show the lender a good credit rating, a solid financial history and a cash flow forecast.” He pointed out that it’s rare for a traditional lender to approve an unsecured loan, with most of those kinds of lending agreements coming from online lenders.

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How an Unsecured Loan Works

Unsecured loans—sometimes referred to as signature loans or personal loans—are approved without the use of property or other assets as collateral. The terms of these loans, including approval and receipt, are most often contingent on a borrower’s credit score. Typically, borrowers must have high credit scores to be approved for unsecured loans.1

An unsecured loan stands in contrast to a secured loan, in which a borrower pledges some type of asset as collateral for the loan. The pledged assets increase the lender’s “security” for providing the loan. Examples of secured loans include mortgages and car loans.1

Because unsecured loans require higher credit scores than secured loans, in some instances lenders will allow loan applicants with insufficient credit to provide a cosigner. A cosigner takes on the legal obligation to fulfill a debt if the borrower defaults. This occurs when a borrower fails to repay the interest and principal payments of a loan or debt.

Types of Unsecured Loans

Unsecured loans include personal loans, student loans, and most credit cards—all of which can be revolving or term loans.

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A revolving loan is a loan that has a credit limit that can be spent, repaid, and spent again. Examples of revolving unsecured loans include credit cards and personal lines of credit.

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A term loan, in contrast, is a loan that the borrower repays in equal installments until the loan is paid off at the end of its term. While these types of loans are often affiliated with secured loans, there are also unsecured term loans. A consolidation loan to pay off credit card debt or a signature loan from a bank would also be considered unsecured term loans.

Unsecured Loan vs. Payday Loan

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Alternative lenders, such as payday lenders or companies that offer merchant cash advances, do not offer secured loans in the traditional sense. Their loans are not secured by tangible collateral in the way that mortgages and car loans are. However, these lenders take other measures to secure repayment.

Payday lenders, for example, require that borrowers give them a postdated check or agree to an automatic withdrawal from their checking accounts to repay the loan. Many online merchant cash advance lenders require the borrower to pay a certain percentage of online sales through a payment processing service such as PayPal. These loans are considered unsecured even though they are partially secured.

Special Considerations

While lenders can decide whether or not to approve an unsecured loan based on your creditworthiness, laws protect borrowers from discriminatory lending practices. The enactment of the Equal Credit Opportunity Act (ECOA) in 1974, for example, made it illegal for lenders to use race, color, sex, religion, or other non-creditworthiness factors when evaluating a loan application, establishing terms of a loan, or any other aspect of a credit transaction.

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While lending practices have gradually become more equitable in the U.S., discrimination still occurs. In July 2020, the Consumer Financial Protection Bureau (CFPB), which takes the lead in supervising compliance and enforcing the ECOA, issued a Request for Information soliciting public comments to identify opportunities for improving what the ECOA does to ensure nondiscriminatory access to credit. “Clear standards help protect African Americans and other minorities, but the CFPB must back them up with action to make sure lenders and others follow the law,” stated Kathleen L. Kraninger, director of the CFPB.

Benefits of unsecured business loans

If your business has enough financial goodwill in the form of a strong credit score and you can afford the interest rates, there are some benefits to obtaining an unsecured business loan.

The first and most immediately apparent advantage is that you don’t need collateral. Usually, lenders want borrowers to put up valuable items like real estate, vehicles, or intangible assets like investment portfolios and business trademarks as backing for the loan. Without the need to put those items at risk of seizure by the lending institution, you can rest easy knowing you won’t lose them if something goes awry.

However, items can ultimately be seized by the lender if they’re included in the personal guarantee that every lender must sign to obtain an unsecured business loan. Such an agreement is legally binding, after all.

Unsecured business loans usually require less paperwork, skip the appraisal process for any collateral and thus have a speedier process overall. Unsecured business loans are also discharged in the event your company goes bankrupt, which isn’t the case for secured business loans.

Risks associated with unsecured small business loans

While the benefits may seem worthwhile, there are some major caveats that you should consider when looking to obtain an unsecured business loan. First and foremost, you may not even qualify for one.

Banks heavily rely on your personal or business’s credit score to determine whether they’re willing to offer you any type of loan, but given the high-risk nature of unsecured business loans, the bar is set much higher. While there’s no minimum credit score you need for a short-term business loan like this, a lower credit score tells the lender that you may have a harder time paying the loan back.

If your personal credit isn’t great, your business has a less-than-stellar credit history or your bad credit regularly keeps you from getting a credit card, let alone some other type of cash advance, your loan application likely won’t land you any additional business financing opportunities anyway. It will always be harder to borrow money if you have trouble making your monthly payments.

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