Unsecured business loans: how do they work?
Unsecured loans allow you to borrow money without risking your assets. Is it worth the high price? Read on to learn more about unsecured loans.
I worked for a few years in a customer contact role selling business loans. I’ve encountered a common refrain among older business owners: “Why can’t you just do it based on my signature?”
For decades, banks made signature loans for borrowers who had a long relationship with them. Loans would be done in one day and the borrower would have cash based solely on his collateral.
Modern banks make finding a small business loan much more difficult. Hundreds of bank failures and thousands of new regulations have made it much harder for banks to lend money in high-risk situations. That said, you may still be able to get an unsecured business loan. Here’s how.
Overview: What are unsecured business loans?
Unsecured business financing occurs when a business can obtain a loan without giving collateral. The majority of business loans are made for direct use (such as real estate or equipment) and the loan is secured by that use. This means that you cannot sell the equipment or real estate without repaying the loan first and if you fail to repay the loan, the bank will repossess the collateral and sell it to reduce the loan balance.
Unsecured business loans are generally for working capital and would rarely be large enough to purchase real estate or a substantial amount of equipment.
How do unsecured business loans work?
If you manage to get an unsecured business loan from a bank (which isn’t easy), you’ll likely need to personally guarantee the loan. This means that if your business defaults on the loan, there will be no collateral to take back and the bank will come looking for you to pay the balance. If you get the loan from an online lender or credit card company, you may not have to personally guarantee it.
Unsecured loans will almost always have higher fees and interest rates; even government-backed microloans can have interest rates up to mid-teens.
4 Types of Unsecured Business Loans
Here are four common types of unsecured small business loans.
SBA loans below $150,000 do not need to be secured. Between $150,000 and $350,000, the bank is required to “seek additional collateral,” but if that exists, the deal can still be made without collateral.
In both of these cases, the bank takes a general UCC deposit on the business. UCC stands for Uniform Commercial Code, and it’s how states register warranties for things like accounts receivable and equipment. You can think of it like the title to a vehicle or real estate.
General UCC means the bank will come after any assets you have that do not have prior liens. These are usually things like desks, computers, and inventory. This means that the loan is not technically unsecured, but is somewhat in business loan purgatory. You are free to do what you want with your assets and resell them if necessary, but the bank will come and collect them if you default.
The most common SBA loans are working capital loans and business loans for startups.
2. Lines of credit
If you have a great relationship with your bank, you may be able to get an unsecured line of credit. Most banks do everything they can to avoid unsecured lines of credit over $50,000. Even then, you’ll likely need to sign the same general UCC as for SBA loans.
A few months ago I was in a deal to do an SBA export line of credit for a company that was buying cornmeal from the US Midwest and shipping it to Indonesia for use as animal feed . The process was incredibly complicated and the SBA required the bank to be #1 on our UCC filing.
It turns out that when signing up, the borrower had secured what he thought was a $25,000 unsecured line of credit from a major bank to make ends meet until we got the SBA approval. The big bank secured his loan with a UCC filing and it was now in the first place. The borrower made an $80,000 cornmeal purchase and needed to be repaid to make his own mortgage payment, but was technically in default on the export loan.
We had to get an emergency conventional loan approved until he was able to get the “unsecured” line of credit closed and the UCC removed. Unsurprisingly, the big bank took its time. Be sure to read the loan documents you sign and know what they mean.
3. Credit cards
Credit cards are the most common form of unsecured business financing. A bank I worked for automatically approved 10% of each loan amount in potential credit cards to try and sell them to customers.
Credit cards are also the most expensive of these options. They have exorbitant interest rates and often have annual fees to get started. If you use them, stick to general operating expenses and pay the balance monthly.
4. Merchant Cash Advance
The reason banks push credit cards on customers is because of high interest rates and hefty merchant fees. Every time you use a credit card, the business owner must pay a merchant fee to process the transaction. Merchant services can be performed through your bank or a third party.
Some merchant service providers will allow you to do a merchant cash advance. It’s like a payday loan for a small business. The merchant services company knows how much you make in credit card transactions and guarantees the transaction based on those inputs.
After getting the advance, the balance is slowly paid off as you accept credit card purchases. As you probably expected, merchant cash advances have quite high fees. Only use them as a last resort.
Should you use an unsecured business loan to finance your business?
Here are some pros and cons of unsecured business loans.
3 Benefits of Unsecured Business Loans
Unsecured business loans can offer attractive benefits.
1. Releases Warranties
The main advantage of unsecured business financing is that you have the freedom to use your assets as you see fit. If you need to sell equipment to move into a new line of business, you can. If you need to factor in your accounts receivable to speed up your cash conversion cycle, you can. If you have a big month and your inventory is sold out, you don’t have to worry about it.
2. Speeds up the approval process
Much of the time underwriting home and equipment loans is evaluating collateral. A big part of the time every month to keep revolving lines of credit open is bringing the borrowing base back to the bank. With unsecured loans, you skip this step.
Additionally, many modern lenders use an algorithm to score and approve unsecured loans because they are smaller than a typical home or equipment loan. This makes the process much easier and faster.
3. Reduces risk
Being able to sell your collateral whenever you want isn’t the only benefit of not getting a loan with it. You will also be able to use the collateral to continue running the business if you are unable to repay the loan. This will give you the opportunity to turn around and possibly repay the lender.
3 Disadvantages of Unsecured Business Loans
However, unsecured business loans also have their drawbacks.
1. Interest rate
There is a clear relationship in finance between risk and interest rate. Lenders who cannot obtain collateral must be compensated for this risk. If you get an unsecured line of credit or credit card, be sure to keep the balance as low as $0.
Lenders know that high interest rates are unattractive and will try to lower rates and offset them with fees such as closing costs, line usage, line non-usage, preparation of documents, the creation of business plans or executive bonuses.
Keep an eye on your loan documents and be sure to review all uses of the loan. Sometimes the lender will pay their fees with the loan so you don’t start with a $0 balance, but you also don’t have to find money for the fees.
I worked with a grumpy old man (whom he would proudly call himself) who was seasoned with decades of working with high-risk companies. He was in the SBA department and often wanted collateral on loans that technically didn’t need it to discipline the borrower.
If a borrower must pledge a second lien on their residence to obtain a loan or declare a borrowing base each month to maintain access to a revolving line of credit, they are much more likely to repay the loan on time.
This discipline is a good thing to have when running a business. The threat of losing critical assets or the need to support a borrowing base helps ensure that you are not living beyond your means. Having an unsecured loan imposes no discipline on your business as there is no direct risk to your assets in the event of default.
Should you get an unsecured loan?
Unsecured loans seem ideal at first sight. You get the money without risking losing anything. In reality, most successful small businesses don’t use unsecured loans a lot because of the expense. Unsecured loans are a step above loans from small business investment companies (SBICs) or mezzanine funds and are often the last gasp of a failing business.