Before you take out a business loan, you need to understand the difference between secured and unsecured loans so you can choose the best option for your business.
When you need a small business loan, one of the first decisions you'll need to make is if you should get a secured or an unsecured loan. Typically, secured loans are preferable for business financing because they have lower interest rates, but lenders can foreclose on your assets if you default. Although unsecured loans don't require collateral, they're harder to get and far more costly than secured loans. Here's what you need to know about these types of loans to determine the best option for your business.
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What is the difference between secured and unsecured loans?
The biggest difference between secured loans and unsecured loans is that secured loans require you to pledge collateral and unsecured loans don't. Unsecured loans are provided based purely on a borrower's ability to repay. So, if the borrower defaults, the lender can sue; however, they won't have liens against any of the borrower's property, so they can't foreclose on and seize any property to get their money back. [Read related article: What Is a Lien?]
Because unsecured loans aren't attached to any collateral, they are riskier for lenders. This makes them more expensive and typically more difficult to get. However, they can also be funded more quickly if you qualify for them.
What is a secured loan?
Secured loans are what most people think of when they think of loans. These include mortgages, car loans, equipment loans, home equity lines of credit (HELOCs), RV loans, tractor loans, boat loans – any loan made against a specific asset, which the lender can take if the borrower defaults.
Because secured loans are attached to specific assets, these loans are considered less risky for the lender – after all, if you don't pay, the lender can still get their money back by taking the asset and selling it. As a result, secure loans tend to have lower rates as well as longer repayment terms. For instance, 15-year mortgage rates are currently under 3%.
Secured loans are ideal if you want long-term financing for expensive assets that you want to pay for over a long period of time. Secured loans are also usually better for people with bad credit; in fact, they're often the only option. [Read related article: Loans You Can Get With Bad Credit]
Secured loan rates and terms
- Interest rates: Starting around 2.8% for personal loans; 5.5% for business loans
- Borrowing limit: Up to 80% to 85% of the value of underlying collateral
- Repayment terms: Up to 30 years
- Example loan: A mortgage on a house
What is nonrecourse financing?
Nonrecourse loans are special types of secured loans that are secured only by the underlying asset.
Most secured loans still require borrowers to sign personal guarantees. In other words, if you default, the lender can take your property and sell it to try to get their money back – and sue you for the difference if your property doesn't fetch enough to make up the loan.
That's not the case with nonrecourse financing. The lender has no recourse beyond foreclosure if you default.
These loans are only used in certain circumstances, most commonly for large real estate acquisitions by established investment groups. Loan amounts are typically large, as are down payments. Terms can also be quite long (30 years or more), and rates are relatively low. In addition, many of these loans have prepayment penalties attached, so you'll pay more if you want to pay back the loan early. Essentially, these are niche lending products that are typically only available to large, sophisticated businesses, but they're great if you can get them.
What is an unsecured loan?
An unsecured loan is any debt that's not secured by an underlying asset. Approval for these loans is based purely on a borrower's creditworthiness, and they usually involve hefty personal guarantees from anyone who owns more than 20% of the business.
Unsecured loans are typically more expensive than secured loans and also have shorter repayment terms, because they're bigger risks for the lender. This makes unsecured debt best for those who need short-term funding that they can access quickly and pay back within a relatively short period (think months rather than years).
However, these loans are only an option if you qualify. Minimum credit scores to qualify are usually 40 to 60 points higher than the minimums for secured loans; most unsecured loans aren't even available if you have bad credit.
Unsecured loan rates and terms
- Interest rates: Start around 6%
- Borrowing limit: Varies based on income; usually, total debt service (with other debts) can't exceed around 36% of your income
- Repayment terms: Typically up to five years
- Example loan: A business credit card
Common types of secured and unsecured loans
Here are several examples of different types of secured and unsecured loans.
- A mortgage: Just about every home loan is secured by the home itself.
- A car loan: Whether you buy new or used, getting a car loan requires you to give the lender a lien on your vehicle, so they can repossess it if you default.
- An equipment loan: As with car loans, lenders that provide financing for pieces of equipment typically place a lien on that equipment.
- A secured credit card: If you don't have established credit and need to start with a secured credit card, you'll have to deposit cash that you can borrow against to use your card.
- An unsecured credit card: Borrowers with established credit can usually get credit cards without first depositing cash.
- A signature line of credit: Some banks and other lenders offer lines of credit that are based solely on the borrower's ability to repay, with no underlying security.
- A consolidation loan: Loans used to consolidate other business debt are not actually collateralized by underlying assets.
- A student loan: Federal student loans can't be discharged in bankruptcy, but they also aren't tied to specific assets that the government can take if you don't pay.
Secured vs. unsecured loan applications
When you apply for an unsecured business loan, the underwriting process is generally pretty simple. A lender will review your tax returns, profit and loss statement, credit report, and bank records to measure your free cash flow. They'll also make sure you have good credit and will be able to cover the cost of the loan. If you meet those criteria, the lender will approve and fund the loan.
The underwriting process for secured loans can be a bit more complicated. This is because the lender has to assess not only the borrower, but the underlying collateral as well. In other words, the lender will want to review everything that would be required for an unsecured loan plus the state and value of your collateral. This typically means ordering an appraisal and potentially an inspection. If the loan is for a business asset like a piece of equipment, the lender may also need to perform a lien search to make sure no other lenders have a claim against that asset.
Pros and cons of secured loans
A secured loan is typically preferable if your business is just getting started or you don't have great credit; in fact, it may be your only option. Secured loans are also usually better because they let you lock in lower rates than are available with secured financing. Finally, if you want longer than three to five years to pay off your loan, then a secured loan is usually the way to go.
- Lenders offer lower rates.
- Longer terms are typically available.
- Underwriting is more complicated because the lender must assess your collateral.
- The lender can foreclose on the underlying asset if you default.
- You'll probably still have to sign a personal guarantee.
Pros and cons of unsecured loans
An unsecured loan is usually only an option if your business is well established and making consistent income. If that's the case and you need access to funds quickly, an unsecured loan may be your best option, especially if you have plenty of free cash flow to pay back the loan in a short time.
- Loans can be funded much more quickly.
- You don't have to worry about a lender foreclosing on your asset.
- You can still be sued if you default on the loan.
- Loans typically have higher rates and shorter terms.
Whether you should get a secured or unsecured loan depends on what you can qualify for and the specifics of your business's financing needs. While secured loans offer lower rates and longer terms, unsecured loans offer fast funding and don't come with the threat of foreclosure. If you have established cash flow and excellent credit and need funds fast, an unsecured loan may be ideal. If you are still building your credit or already have a lot of loans outstanding, a secured loan may be your best bet.