If you want to grow a business, you usually need a loan. Fresh capital provides you with resources to buy equipment, hire new people and offer more locations to make more sales. It’s risky, but the payoffs can be enormous.
Business loans fall into two categories: secured and unsecured. In this post, we’re going to look at both in turn and then ask which you might want to use.
What Is A Secured Loan?
A secured loan is a type of credit agreement where a lender sends you cash, and in return, you promise to pay them back in the future, either with your business revenue or, failing that, by selling assets. The term “secured,” therefore, refers to the fact that the lender can get their money back by selling collateral even if you can’t afford to make cash payments.
Legally speaking, lenders are entitled to “seize” your assets if you don’t make good on the loan. Bailiffs arrive at your business, and forcibly acquire your assets. Courts can also rule that you must sell the buildings you own, even if you need them for operations.
Lenders won’t usually provide secured loans up to the full value of your assets. So, if you own equipment worth £100,000, they won’t provide you with a similar amount.
The main reason for this is the fact that your assets depreciate. If you were to sell all your assets next year, for instance, they might only be worth £90,000, cutting into the total amount of money that the lender could clawback.
What Is An Unsecured Loan?
By contrast, unsecured loans don’t require any collateral. Here, the lender sends you cash, and you promise to pay them back in the future – both the principal plus some interest.
Historically, some exceptionally creditworthy businesses were able to take on unsecured loans at low-interest rates, but they’ve become increasingly rare over time. Most small business owners can’t obtain them.
That’s not to say, however, that SMEs don’t have access to unsecured credit – they do; it just comes through a different channel. Nowadays, business executives can obtain unsecured loans through credit cards and even personal loans.
Of course, when lenders face higher risks, they want more compensation. That’s why interest rates on any kind of unsecured loan – be it from a bank or on a credit card – is much higher than secured.
Which Type Of Loan Should You Choose For Your Business?
Generally speaking, you’ll want to avoid using unsecured loans for long-term borrowing. High interest rates on these products are crippling, and you’ll wind up with cash flow issues, even if your company is profitable.
There are circumstances, however, where unsecured loans are a good idea. For instance, if you’ve just completed a major contract and are awaiting payment, it’s okay (though not ideal) to use credit cards to pay suppliers and employees until the money comes through.
In most cases, though, you’ll want to use secured loans. Because lenders have collateral should you fail to make cash payments, interest rates on this kind of borrowing are much lower, often simply reflecting the time value of money. That is, how much do lenders want you to pay them for depriving them of the use of their money right now?
Of course, if you are a startup, you don’t have any assets that can serve as collateral in your business. You’re yet to generate the revenue that will allow you to build your capital base organically. In these cases, you have no choice but to accept an unsecured loan, either from a bank or, more commonly from an angel investor. Just be aware that lenders may attach non-financial conditions to their loans, such as a share in the future equity of your business or a veto on the board. Again, you must decide whether the costs are worth the benefits. Usually, they are.
Can You Get Capital With Limited Assets?
Sometimes your expansion plans require a lot of capital to get off the ground. But what if you don’t have enough collateral to get the money you need? It turns out that many lenders are willing to lend you more than the value of your assets if they believe that your plans stand a high chance of success. You may be able to borrow over 300 per cent of the value of your collateral under the right conditions.
So, in summary, both types of loans have a purpose, but, in general, you’ll want to stick to the secured variety for any long-term borrowing.