Secured vs. Unsecured Business Loans

When you need extra working capital, choosing the right type of small business loan or business line of credit is crucial. Business financing generally falls into two main categories: secured and unsecured. Each has its benefits and drawbacks, and the right choice depends on factors like your business’s financial health, business plan, credit history and the level of risk you are willing to take.

Let’s explore the differences between secured and unsecured business loans, and how to determine which funding option is best for your business.

What’s the difference between a secured and unsecured business loan?

A secured business loan requires the borrower to provide collateral — an asset that the lender can seize if the loan is not repaid. Common types of collateral include real estate, equipment, inventory or accounts receivable. Because these loans are backed by assets, they generally come with lower interest rates and higher borrowing limits.

An unsecured business loan, on the other hand, does not require collateral. Instead, lenders approve these loans based on the borrower’s creditworthiness and revenue history. Since unsecured loans increase the lender’s risk, they often come with higher interest rates and stricter qualification requirements.

What is collateral?

Collateral is an asset that a borrower pledges to a lender to secure a loan. It serves as a form of protection for the lender, ensuring that if the borrower defaults, the lender can recover the funds by seizing and selling the collateral. Collateral can take many forms, including:

Real estate. Business owners can use owned personal or commercial property to secure a loan, giving lenders confidence that they can recover their funds if needed.

Business equipment. Machinery, vehicles or other essential tools can be pledged as collateral, especially for businesses that rely on expensive assets. Some types of financing, such as equipment financing and some types of auto loans are structured this way.

Inventory. Retailers and wholesalers can use inventory as collateral, allowing them to access funding based on the value of their stock.

Accounts receivable. Businesses that invoice clients can use outstanding payments as collateral, ensuring lenders have a fallback option. Merchant cash advances may also provide upfront funding to businesses that pledge repayment via a percentage of their business’s credit card sales.

Cash deposits or investments. Savings, investment accounts or certificates of deposit (CDs) can serve as collateral, providing a liquid asset that lenders can easily claim if necessary.

The value of the collateral must typically match or exceed the loan amount to be considered acceptable by lenders.

What are the pros and cons of a secured business loan?

Pros of a Secured Business Loan

Lower interest rates. Since secured financing options pose less risk to lenders, they typically come with lower interest rates.

Higher loan amounts. Businesses can borrow a larger amount of money because the loan is backed by valuable assets.

Longer repayment terms. Secured loan terms often have more extended repayment periods, making monthly payments more manageable than unsecured loans with shorter repayment periods.

Broader eligibility. Businesses with weaker credit histories and lower credit scores may still qualify if they have valuable collateral.

Cons of a Secured Business Loan

Risk of losing collateral. If a business defaults on the loan, the lender can seize and sell the pledged assets.

Longer approval process. The lender must assess the value of the collateral, which can slow down the approval time.

Potential for over-borrowing. Since businesses can borrow more money with collateral, they may take on excessive debt that becomes difficult to manage.

What are the pros and cons of an unsecured business loan?

Pros of an Unsecured Business Loan

No risk to assets. Since no collateral is required, entrepreneurs do not risk losing valuable assets if they default.

Faster approval process. Without the need to evaluate collateral, the loan application process and funding times are generally quicker.

More flexibility. Unsecured loans can be used for various business needs, from expansion to short-term cash flow gaps.

Good for established businesses. Companies with strong financials and business credit history can often secure favorable terms.

Cons of an Unsecured Business Loan

Higher interest rates. Since the lender is taking on more risk, interest rates are typically higher.

Lower loan amounts. Borrowing limits are often lower compared to secured loans, leading to approvals for smaller loan amounts.

Strict qualification requirements. Businesses must demonstrate strong creditworthiness and steady revenue to qualify.

Personal guarantees may be required. Lenders may require a personal guarantee from the small business owner, putting their personal assets at risk in case of default.

Is a secured or unsecured loan right for my business?

The choice between a secured and unsecured business loan depends on several factors:

Your business’s financial health. If your business has strong financials and a solid credit history, you may qualify for an unsecured loan with reasonable terms. If not, a secured loan may be the better option.

Available assets. If you have valuable assets that you are comfortable using as collateral, a secured loan could provide better rates and terms.

Loan amount needed. If you need a larger amount, a secured loan may be the better option since financial institutions are more willing to offer higher limits when collateral is involved.

Urgency of funding. If you need funds quickly, an unsecured loan might be preferable due to its faster approval process.

Risk tolerance. If you prefer to avoid the risk of losing business assets, an unsecured loan may be the safer choice, despite the higher interest rates.

The Bottom Line

Ultimately, the right type of financing depends on your business’s specific needs, financial situation and long-term goals. If your business requires a large sum and has assets to offer as collateral, a secured small business loan might be the ideal solution. Conversely, if you need quick access to funds without putting assets at risk, unsecured loan options could be the better choice. Carefully evaluating the advantages and potential risks of both options will help you make an informed decision that aligns with your business strategy and long-term growth objectives.