Secured vs. Unsecured Business Loans: What You Should Know About Each

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 they are considered riskier by financial institutions than lending to larger businesses.

If you’re exploring commercial lending options, you may have noticed that banks offer “secured” loans with more attractive interest rates and payment terms.

What is a secured loan? 

A secured business loan requires collateral, such as commercial property, which the lender can claim if you fail to repay your loan. Secured 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.

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 risk in offering a loan because there’s always the possibility that a business will fail and cannot make its payments. The main difference between a secured and an unsecured loan is how a lender mitigates that risk.

While a secured business loan requires a specific piece of collateral, unsecured loans are not attached to collateral. Personal loans, student loans, and credit cards are common examples of unsecured loans. These types of business loans often come with high interest rates and stringent approval requirements.

Personal guarantees and blanket liens

Because of the increased risk to the lender with an unsecured loan, you may be asked to sign a personal guarantee. 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 reserving the right to file a blanket lien on your business assets. 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.

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.

But 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 for making 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, 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, you can pledge personal assets.

Prerequisites for secured business loans

Most loan applicants will be asked to satisfy certain prerequisites, regardless of the business loan they apply for. Be prepared to supply:

• Your credit score.
• Your time in business (most lenders require a minimum of one to two years in business).
• Your business’s annual revenue.
• A business plan.
• Financial statements.
• Collateral (if applicable).

Every lender asks for different documentation, so check the requirements carefully before starting any loan application.

Collateral 101: What lenders accept, and how they value it

Lenders evaluate collateral based on three criteria. They want to know how easily the asset can be appraised, how liquid it is, and how stable its value is over time. “The easier and faster a lender can turn an asset into cash, the more favorably they view it as collateral,” wrote Crestmont Capital.

Common collateral types include: 

• Real estate.
• Equipment.
• Inventory.
• Accounts receivable.
• Savings or investments.

Commercial properties, land, office buildings, even residential property owned by a business owner are highly regarded collateral assets. Real estate holds its value well and is difficult to hide or move. Machinery, vehicles, or tools used in business operations can also be used to secure a loan, as can unsold inventory (especially useful for retail businesses).

The LTV ratio for each type of collateral varies. Commercial real estate is typically accepted at 75% to 90% of appraised value, new equipment at 75% to 80% of purchase price, and accounts receivable at 70% to 80% of the eligible invoice value.

“Generally, lenders want collateral coverage of at least 100-125% of the loan amount (meaning $100,000-$125,000 in collateral value for a $100,000 loan). Higher-quality, more liquid collateral allows for better LTV ratios and may require a smaller total collateral pool,” wrote Crestmont Capital.

How liens and personal guarantees affect future financing

When you borrow using collateral, the lender will publicly claim a lien against your business assets. “ A lien lets a creditor seize and sell collateral if a borrower defaults on a loan. Borrowers cannot sell liened property without the lien holder's consent,” wrote Investopedia. “Liens can be voluntary, as when a property is used as collateral for a loan.”

Once a lien is in place, it signals to other creditors that your assets are already pledged. This can make it harder to use, sell, or transfer your assets. “For example, if a business has a lien on its inventory, it may not be able to sell it to generate cash flow or use it as collateral for another loan,” wrote FasterCapital. “A lien also makes it harder for a business to relocate, expand, or downsize, as it may need the creditor's consent to do so.”

Alternatively, you can offer a personal guarantee in place of a lien. If the business can't repay its debt, you are obligated to cover the loan balance. If you work in an LLC or S corporation, you are waiving the liability protection inherent in those business structures.

“A personal guarantee can make credit less expensive for a business. But if the business isn't able to generate enough revenue and earnings, an individual could suffer significant losses,” wrote Investopedia. “If a personal guarantee is in place and the business defaults, the principal is personally liable. It gives creditors a legal right to all of an individual's pledged personal assets.”

Some lenders require personal guarantees, so know what you’re signing up for.

Types of secured business loans

Here are a few types of secured business loans.

Term loans

Term loans usually require collateral and have a set repayment schedule and a fixed or floating interest rate. The amount of collateral used and the borrower’s current credit score determine the amount the financial institution will approve for the loan. While terms vary, a term loan generally ranges from one to 20 years for repayment and can range in coverage from $25,000 to $500,000. Term interest rates range from 5% to 25%. Business owners can use term loans to cover a wide variety of business expenses.

SBA loans

U.S. Small Business Administration (SBA) loans are another example of secured business loans. Three of the most popular loan programs — the CDC/504, a microloan, and a 7(a) loan — are SBA loans. An appealing aspect of an SBA loan is the lower interest rates. Rates vary depending on the agreement with the lender, but they typically range from 4% to 13% interest. Terms can vary from five to 25 years. The 7(a) loan program offers up to $5 million.

Business lines of credit

A business line of credit works like a credit card. You have access to capital and can withdraw as needed, paying interest only on the funds used. Loan amounts range from $10,000 to $1 million. The repayment schedule depends on your lender, and you can pay anywhere from 7% to 25% in interest.

Equipment financing

This loan specifically finances the equipment needed for your business, and the loan amount can only be up to the cost of the equipment. The terms typically match the length of the expected lifespan of the equipment. Interest ranges between 4% and 40%, depending on your credit and how new your business is.

Invoice financing

Invoice financing uses outstanding invoices as collateral to guarantee the loan. This can benefit companies that experience delayed payment from clients, since it provides the funds instantly through the loan. Often, lenders advance up to 85% of the invoices used for collateral. Lenders keep the remaining 15% in reserve and release it on a schedule and rate based on when the borrowing business receives payment for its invoices.

Inventory financing

This is a self-secured loan, similar to equipment and invoice financing. Inventory financing does not use personal assets to secure the loan. There are various types of inventory financing loans, such as a medium-term loan, a line-of-credit loan, and a short-term loan. You receive an advanced sum from the lender you'll use to buy inventory. If the inventory does not sell, then it is used as collateral for the lender to sell to recoup the loan amount.

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 pay off the loan or, at the very least, the interest on the money you borrow.

Secured loans come with advantages over unsecured loans. Here are the pros and cons of secured business loans:

Pros of secured business loans

• Lower interest rates: Secured loans are less risky for 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 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 set realistic budgets and 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 poor credit, an unsecured loan may be impossible to obtain until you rebuild your credit. Since secured loans rely on collateral, lenders are more willing to offer a loan.

Cons of secured business loans

• Potential loss of assets: 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 significant 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 easy approval.

According to National Business Capital and Services, ask yourself the following questions before applying 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?

[Read more: 100+ Grants, Loans, and Programs to Benefit Your Small Business]

How to get a secured business loan

Get your finances in check

To help secure a loan for your business, start by checking your eligibility. Review your credit score and credit history before starting the loan process, since this largely factors into the loan’s approval, rates, and terms.

Compare different loan types

Determine your business’s specific loan needs and educate yourself on how each loan works and what the repayment details are. Additionally, consider factors like collateral, the loan amount, and interest rates. Have realistic expectations about what you can offer upfront for collateral and for your repayment schedule.

Research your lender

Take your time when researching your options. Check online as well as at local financial institutions. Make sure your chosen lender is well recommended and transparent about the process. Compare terms and rates with different lenders to see where you can get the best deal.

Organize your documents and fill out your application

Create, find, and gather all the necessary documentation into a single folder for the application before you start the process.

Once you fill out a formal application form, do not rush the paperwork and signing process. If there is any part of the process you don’t understand, ask questions. Be meticulous, as mistakes can result in being approved for a lower amount or even being denied.

Fully understand the expectations of the loan agreement before signing. If you’re ready to talk to lenders, our guide on preparing to apply for a business loan can help.

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