How To Decide Between Secured And Unsecured Financing

If your business needs to raise some capital or asset finance, then it can be daunting to know where to look and who to turn to. Obviously, the classic option is the banks and credit lenders who have been lending to businesses for hundreds of years now and specialise in B2B finance. If you are looking to borrow for your business though, then the first thing you need to work out is whether you are looking for secure, or unsecured finance. Providers like NetCredit offer a useful starting point when exploring lenders.

 In this post, we shall take a look at both of these financing options and examine the differences between them as well as the pros and cons of each. Let’s begin. 

What Is Unsecured And Secured Finance

Unsecured finance is when an institution lends money or credit to you personally (or your business’ corporate entity) and does NOT secure it against any asset. All they have is your word that you will pay it back and if you default on payments, then they can of course seek legal action against you or your business, but they are not really entitled to take anything* (*although they can get various court orders to try and take your personal belongings). If you are unable to repay them, then the bank may simply have to suck it up and take the loss. 

Unsecured lending is a lot riskier from a lender's perspective and for this reason, it usually comes with a much higher interest rate. Classic examples of unsecured lending are credit cards, overdrafts and small personal or business loans.

Secured lending or finance is when a bank or credit agency lends you money or extends your credit but secures their debt against an asset you own. Classic examples of debt security are property although cars, jewellery or racehorses can also be offered.

 Basically, if you default on your credit payments, then the lender has the right to take your asset and sell it to repay the debt. This may mean them kicking you out of your house, taking over your store, towing your car away or sending that price racehorse to the knacker’s yard.  

Secured lending is a lot safer for the banks as they tend to make sure that the value of the asset is adequate to cover your lending. For this reason, secured lending comes with much lower, sometimes almost generous interest rates. An obvious example of secured lending is a mortgage, but large loans are also usually secured against property or other high-worth assets.

How Do You Decide Between Your Options As A Small Business

In a lot of cases, this will be a no-brainer. If you are a start-up and you personally own no property nor possess any assets of value, then you will probably not be able to obtain any form of secured lending whatsoever and therefore this choice makes itself.

However, if for example you own your home, then you may wish to offer this as security for your start-up business lending. This will allow you to borrow more, and at a lower interest rate. However, if your business fails (which most do) and you can't pay the bank back, then they will seek possession of your home. This does sound intimidating and is a very scary prospect. However, banks only ever seek to repossess homes as a last resort. It is bad for their reputation and is simply bad for their business. 

There are also a few instances of “in between cases” such as ones concerning equipment finance. For example, let's say you borrow $50k to start up a food truck business, then you can offer the food truck itself as partial security in which case a portion of the loan will be secured (ie, the value of the truck) and a portion of it will be unsecured. This will usually mean dual interest rates being applied which whilst complicated, will work out cheaper for you.

Note that whilst you can offer personal items such as jewellery as security, the bank may insist on holding onto these, meaning you won’t be able to wear that diamond necklace to the summer gala unless you repay that pesky loan first.

Pros And Cons of Unsecured Lending

Pros - The main pro of unsecured business finance is that if you can’t repay it, you don’t lose any assets and can just walk away from the debt. 

Firstly, you can’t really ever just “walk away” from a debt. If your business fails and you are unable to pay it then the creditor won’t simply forget. You will probably remain personally liable for the debt and will struggle to obtain credit again. At the very least, your business will be forced into insolvency. 

Furthermore, in most jurisdictions, a creditor does have the right to take legal action for enforcement of an unsecured debt. This means that they can get court orders to take any assets you or your business have and so in reality, they may still end up trying to take your house, car or food truck. Bear in mind that they will add all legal and enforcement costs to your debt, and these can be very high.

A genuine benefit of unsecured loans however, is that they are usually a lot faster to turn around and some can even be arranged in just one day.

Cons - Unsecured finance is more expensive. Interest rates on unsecured lending are always a lot higher than on secured lending. A typical credit card APR is 17% and an unsecured loan rarely comes in at less than 10%. Bearing in mind that mortgage interest rates currently range from 2.5 - 5%, that's a noticeable uplift.

Also, unsecured lending generally offers much shorter repayment terms. A typical personal loan repayment period is 3 - 5 years.

 Pros And Cons of Secured Lending

Pros - Lenders are a lot more comfortable with secured business financing and so offer better interest rates. If for example, you decide to re-mortgage your house to finance your business, you may even be able to find an interest rate as low as 2.5%. You can also take out secured lending over longer terms of up to 25 years. 

Cons - Of course, the flip side is that if you fall behind on your payments, the lender will be looking to take your security. In most jurisdictions, mortgages become in “default” and liable for repossession after 2 months’ worth of missed payments which doesn't give you much breathing space if your business goes through a rough period such as a global pandemic.

However, the reality is that lenders are rarely ever so fast to enforce secured debts. Banks do not like repossessing and you can typically work with them to restructure the loan or take payment holidays.

In Conclusion

 Basically, the only reason to ever take out unsecured lending is pure necessity. On the contrary, secured business loan means you can borrow more, for less, over a longer term. You do risk losing your asset but in practice, even an unsecured lender will eventually start coming after any assets you have should you struggle to repay them.