For many entrepreneurs, a small business loan is the best way to finance a new business or grow an existing organization. However, obtaining a business loan can be difficult for startups and small companies because the risk to financial institutions is greater than lending to larger businesses.
If you’ve begun to explore commercial lending options, you may have noticed some banks offer “secured” loans with more attractive interest rates and payment terms.
To help you determine if you’re eligible for a secured business loan — and whether it’s the right choice for your financial situation — here’s what you need to know.
Secured vs. unsecured business loans
Any commercial lender takes on a significant amount of risk in offering a loan because there’s always the possibility that a business will fail and be unable to make payments. The main difference between a secured and an unsecured loan is the way a lender mitigates that risk.
A secured business loan requires a specific piece of collateral, such as a business vehicle or commercial property, which the lender can claim if you fail to repay your loan. These types of loans are often easier to obtain and may come with lower interest rates because the lender has a guaranteed way to get their money back. They can recoup their losses by selling your collateral in the event of a default.
Unsecured loans, on the other hand, are not attached to any collateral. Personal loans, student loans and credit cards are common examples of unsecured loans. These types of loans often come with high interest rates and stringent approval requirements to ensure the lender gets their money back.
Personal guarantees and blanket liens
Because of the increased risk to the lender with an unsecured loan, they may ask you to sign a personal guarantee to approve it. This means that, if your business defaults on the loan, you are personally liable for repaying it.
While a creditor can’t seize your business property under a personal guarantee, they can legally claim your personal assets, such as bank accounts, cars and real estate, until the loan is repaid.
Another common method of mitigating lending risk is by reserving the right to file a blanket lien over your business assets. According to Fundera, most business loan terms include a blanket lien clause that allows the lender to claim and resell your business assets to collect on your debt.
While many entrepreneurs use their business assets as collateral, it is also possible to use your personal assets to secure a loan.
How do secured business loans work?
The Balance explains that the amount of money you can borrow against collateral depends on the loan-to-value (LTV) ratio offered by your lender.
For instance, if your collateral is worth $100,000 and the lender allows for a 75% LTV ratio, they can lend you a maximum of $75,000.
Keep in mind that if your pledged assets lose value, you may be required to pledge additional assets to maintain a secured loan. Additionally, if your lender takes your assets and sells them for less than the amount you owe, you are responsible to make up the difference.
There are several types of collateral you can use to obtain a secured loan. In fact, any asset a lender feels holds significant value can be used as collateral, including some surprising items. However, the most common types of collateral include:
- Real estate
- Vehicles
- Machinery and equipment
- Accounts receivable
- Investments
- Bank accounts
- Insurance policies
While many entrepreneurs use their business assets as collateral, it is also possible to use your personal assets to secure a loan.
Pros and cons of secured business loans
Borrowing money always comes with risks and you should always be wary of falling into a debt trap. Before considering a loan, evaluate your business and make sure you will be able to pay off the loan or, at the very least, the interest on the money you borrow.
However, secured loans do come with some significant advantages over unsecured loans. Here are the pros and cons of secured business loans:
Pros
- Lower interest rates. Secured loans are less risky to the lender as they come with collateral. If you have a steady income, valuable assets and good credit history, you can shop around for the lowest rates.
- Bigger loan amounts. Generally speaking, you can obtain a much higher loan amount through a secured loan as the lender assumes less risk. The more valuable your collateral is and the easier it is to access, the larger the loan amount.
- Longer repayment periods. Secured loans usually come with better repayment terms, allowing borrowers to pay off the loan over several years. Home loans, for example, are often repaid over 30 years.
- Easier to obtain with poor credit. If you have a poor credit history, an unsecured loan may be virtually impossible to obtain until you spend months or years rebuilding your credit. Since secured loans rely on collateral, lenders are more willing to offer a loan.
Cons
- Potential loss of assets. The biggest downside to a secured loan is that the lender can seize an expensive, valuable business asset if you default. If you’ve invested a lot of money in that asset and have built up equity, you can lose it all instantly if the lender claims that property.
- Credit damage. Defaulting on any loan can significantly damage your credit and your ability to borrow in the future. If you hit a rough patch, some lenders will help you avoid default, as it’s sometimes easier to assist during a temporary lapse than it is to collect and sell the collateral.
Is a secured business loan right for you?
If your business doesn’t have much in the way of assets, you might not be eligible for a secured business loan.
However, if your business has a valuable asset that could be put up as collateral, and you are confident about your ability to repay the loan, a secured loan is your best option for good loan terms and an easy approval process.
According to National Business Capital and Services, you should ask yourself the following questions before you apply for a secured business loan:
- Which assets do you feel comfortable leveraging?
- What kind of repayment terms are you looking for?
- How much do you need to borrow?
- What are you going to use the money for?
If you’re ready to start talking to lenders, our guide on preparing to apply for a business loan can help.
CO— does not review or recommend products or services. For more information on choosing the best business loan and financing options, visit our friends at business.com.
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