An unsecured business loan is a business loan given by a lender to a borrower without any collateral. The sole criterion for the loan is the borrower’s creditworthiness. Some unsecured loans are personal loans or signature loans, not having to do with a business entity, but unsecured business loans are written for the purpose of helping a business in some way.
Because there is a higher risk involved in giving an unsecured business loan, lenders generally only extend them to borrowers with excellent credit scores.
Business owners looking for an unsecured business loan often work closely with a bank where they do all of their business banking or opt to pursue a loan through alternative lenders. One option is an unsecured loan that does not rely on specific collateral but puts a lien on the business’s assets until the loan is repaid. This can be an alternative for those who do not want to tie up specific assets or property or who do not have a great credit score.
How Secured and Unsecured Business Loans Differ
A secured business loan is the most common kind of business loan. It uses specific assets or property as collateral for the loan. If the loan is not paid back, then the lender can seize the collateral as payment. This makes the loan more secure for the lender. An unsecured business loan does not require collateral, so it is riskier for the lender, who runs the chance the borrower may default on the loan without any collateral to offset the loss.
Because of the higher risk, lenders tend to charge a higher interest rate for unsecured loans. They expect the borrower to have a higher credit score than they would expect for a traditional, secured loan. As an alternative, the bank or lending institution may let another individual cosign the loan. In the event the borrower defaults on the loan, the cosigner is responsible for paying off the debt.
Types of Unsecured Business Loans
While all unsecured business loans have a few things in common, such as higher interest rates and no collateral, there are a few differences between the various types. These different types have different pros and cons for business owners.
Business Line of Credit
A business line of credit has a credit limit that allows the borrower to use the funds, pay them back, then use them again, much like using a credit card for purchases. An unsecured business line of credit is often used for ordering inventory, growing a business or filling gaps in cash flow. As long as the borrower makes the minimum payment each month, the line of credit never goes away and can be used at any time.
Related Article: Discover How to Establish a Line of Credit
The borrower is only charged interest on the amount of the line of credit in use. For instance, if they have a $10,000 unsecured line of credit but only use $4,000 of it, then they only pay interest on the $4,000. Over time, the credit limit may or may not be increased depending on the borrower’s creditworthiness, timely payments and other factors.
Unsecured Term Loan
An unsecured term loan for business is a loan for a set amount. The borrower has to pay a set, minimum amount on a set schedule (usually monthly) until the debt is paid in full. There is a set term for the loan and the entire amount must be paid off by the final due date.
Each payment includes a portion going toward the principal (the loan value) plus any interest for that time period. The longer the repayment period, the lower the monthly payment is, but the interest paid over time is greater.
A riskier type of unsecured business loan is based on invoice financing. This is essentially a loan against the value of the business’s outstanding invoices. If a business has severe cash flow problems but a significant number of outstanding invoices, then this can be an option but it is costly. The business sells its unpaid invoices to the lender at a discount and receives a lump sum upfront based on the value of the invoices.
The lender keeps a part of this amount until all the invoices are paid. This is considered an unsecured loan because there is no guarantee the invoices will be paid and they do not have value in and of themselves. There are fees and interest charged on the amount advanced.
Merchant Cash Advance
A merchant cash advance is another high-risk form of unsecured business loan that has one significant advantage: quick access to emergency cash. The lender provides a lump sum of money in exchange for a percentage of future sales. Repayment of a merchant cash advance (MCA) includes the lump sum plus interest and fees. The higher the risk for the lender, the higher the fees and interest.
The repayment is handled as either a percentage of credit and debit sales or a fixed amount transferred directly from a bank account so it is difficult to default on the payments. Because the fees and interest can add up rapidly, this is often a last resort for business owners who need an unsecured loan quickly for a one-time expense.
Defaulting on an Unsecured Business Loan
When a business owner defaults on a traditional, secured loan, the bank or lending institution can take the collateral as payment of the outstanding debt. With an unsecured loan, this option is not available. Instead, the lender may sue the borrower in court or turn over the debt to a collection agency.
In court, if the lender wins a judgment against the borrower, then the individual’s wages can be garnished or a lien can be placed against the borrower’s home or other personal property. If a business owner is sued for defaulting on an unsecured business loan, then he or she may lose not only personal property but the cost of an attorney and court fees as well.
Advantages and Disadvantages of Unsecured Business Loans
Advantages to unsecured business loans:
- They are easier to obtain and are processed more quickly than secured loans because they are based solely on a credit score. This means you can get the money quickly if you need it right away.
- If you default on the loan, then the lender may or may not pursue you in court. Sometimes the lending institution decides it is not worth pursuing.
- If your business has to declare bankruptcy, then an unsecured loan will be discharged in court, while a secured loan usually still has to be paid, whether in payments or with your collateral.
Disadvantages to unsecured business loans:
- It can be more difficult to get approval for an unsecured business loan because of the risk, and you need to be sure you have a good credit rating before applying.
- Defaulting on an unsecured loan may not lead to confiscation of collateral, but it affects your business’s credit score.
- Because of the risk involved, lenders charge higher interest on an unsecured loan, meaning you pay more over the life of the loan than you would with a secured loan. You also have to pay higher monthly payments, which can impact your operating budget.
Related Article: What Affects Credit Scores