Business Loan: Secured or Unsecured?

Suppose your small business needs more cash than can be supplied through a line of credit or personal credit cards. In that case, it may be necessary to apply for a small business loan.

As with any form of financing, debt structure, interest rates and payment schedule will depend on the bank, lender's credit history, health of the business and vintage. Owing to these factors along with many others, many times you might not either be able to receive the desired loan amount unless it is secured or at a much higher interest rate. Taking these factors into consideration, before applying for business funding, it is suggested that you determine whether you will need to pursue a secured or unsecured loan.

Secured Loan: the most common and straightforward lending option because they are backed by an asset, either personal or business related. If the borrower defaults, the business lender assumes ownership of the property and may try to recoup their loss by selling it. The types of collateral that could be used to secure a loan: Unpaid Invoices, Inventory, Equipment, and Real Estate (Commercial and/or Personal).

As a small business owner, you may benefit from this option if you want to limit your personal risk in the investment or want lower interest rates and the ability to pay back the investment over a longer period.

Pros:
a) NBFCs and banks are willing to work with small businesses when their investment is assured

b) these allow you to pay back over time for large purchases that you don’t expect to pay off quickly

c) can have a longer payback period of up to 30 years.

d) less risk to lender owing to lower risk backed by a collateral

Cons:

a) limited by the fair value of the asset pledged as collateral

b) the lender has legal authorization to seize the asset if the agreed-upon payments are not made on time

Unsecured Loans: means that the borrower doesn’t have to provide collateral to qualify and receive financing.

Unsecured business loans may be viable for business owners with a strong personal credit score. However, this type of business financing represents more risk to the lender. If you borrow money and default on your payments, there is no asset to seize. Hence, unsecured loans typically come with stringent standards (such as credit score requirements) and higher interest rates. In addition, at times, banks may require a different security feature as an alternative to collateral – like a percentage of your credit card transactions or POS (Point of Sale) transactions.

As there is no collateral attached, the corrective actions that can be employed by the lender in case of a default --
a) Legal action

b) Employ collection agency

c) Sell debt to 3rd Party

Pros:
a) Due to absence of collateral, the disbursal process bypasses lengthy appraisal 

b) in case of bankruptcy of business, the loan has the potential to be forgiven

Cons:

a) more expensive as the risk to lender is higher

b) shorter repayment periods - up to 36 months in most cases

c) harder to obtain as the risk must be absorbed for non-repayment

Defaulting on unsecured business loans can mean financial ruin and damaged credit, so make sure you’re confident in your business before applying.

For new entrepreneurs, secured business loans may be the only available option. Unsecured credit can offer more flexibility, larger amounts, and faster access to cash for established business owners willing to pay higher interest rates. However, they may be held personally accountable if the business defaults.

Entrepreneurs may also want to consider partially secured loans, where the collateral is required but doesn’t have to cover the principal. Lenders assume less risk with these loans because they typically aren’t discharged by bankruptcy. Therefore, the pledged asset guarantees some return in the event of default. Banks may offer more attractive terms for partially secured loans than unsecured, such as lower interest rates and longer repayment time.