Managing Debt Responsibly: Best Practices for Utilizing Unsecured Funding

What Unsecured Funding Really Means for Small Businesses

Unsecured funding usually means financing options that do not need collateral to secure the capital. Simply put, with these types of financing options, a lender cannot repossess any business or personal assets if payments stop or a borrower defaults on the loan. Instead, funding decisions are based on a borrower's creditworthiness, credit history, and cash flow. These are the numbers that tell a lender whether a business can realistically repay the loan or not.

This is different from a secured business loan, where an asset such as equipment, real estate, or receivable is used as collateral. With no asset securing the loan, the lender is taking on more risk. That can mean stricter credit requirements and a higher interest rate or APR. The U.S. Small Business Administration also notes that unsecured business loans are likely to have higher interest rates than secured loans. Even with the higher cost, unsecured funding may make sense for business owners who do not have suitable collateral or do not want to use business or personal assets to secure a loan.

Types of Unsecured Business Loans Every Owner Should Know

When it comes to unsecured funding options, it is important to keep in mind that each option is different than other. The options for unsecured business loans range from credit lines to unsecured term loans. Each of them is designed for different goals. Here is a list of options that borrowers should explore:

• Unsecured term loans offer lump sum amount upfront, which the borrower agrees to repay over a set time period. This type of funding is useful when it comes to large, one-time expenses like renovations or equipment.

• An unsecured business line of credit provides businesses with a set amount of money without needing them to borrow everything at once. qualifying businesses can use the funds when needed and generally pay interest only on the amount it has drawn.

• Business credit cards can work for smaller or recurring expenses that the business expects to repay relatively quickly. The available credit is usually lower than what a business may be able to get through a term loan or line of credit.
• Short term unsecured business loans are generally repaid over a shorter period and may have a faster application process. They can make sense when a business needs money for a temporary shortage or immediate expense rather than something it will be paying for over several years.

Can Unsecured Business Loans Help You Buy a Business?

Some business owners do use unsecured business loans to acquire a business. Sometimes, this type of funding is also used to buy out a partner, typically when the purchase price of a business is moderate, and the business owner has strong personal credit. Lenders, who review these applications, typically have requirements for documentation including a copy of your most recent tax return(s), bank statements, and a summary of the cash flow of the business you are purchasing prior to a positive funding decision. Since no collateral is required, loan approval is based primarily on the buyer's (applicant's) personal creditworthiness and the acquired business's ability to produce steady cash flow following the completion of the sale.

When Short Term Unsecured Business Loans Make Sense

Short-term unsecured business loans serve best as a source of cash when a company needs it in a hurry, and the business can pay it back in months as opposed to years, not when the business is looking at long-term growth.

These loans may be helpful for transient costs that include replenishing stock, doing payroll when a big payment is on the way, or riding out a slow month. Because the payback period is shorter, they typically make more sense for costs the company anticipates recouping relatively quickly. Some online lenders also offer a relatively quick application and approval process, with funding sometimes available within a few business days.

The tradeoff is cost. These loans usually carry a higher effective rate than longer unsecured funding options, since the lender recovers the return over a compressed repayment period. So, the real question is not how fast the money arrives, but whether the business can comfortably absorb the repayment terms once funded.

Why Debt-to-Income Ratio Decides Your Loan Approval

Debt-to-income ratio (DTI) is a metric that is used to measure how much of a business's income is already going for debt payments before a new loan comes into the picture. Lenders rely on this metric with unsecured funding, especially since there is no collateral to fall back on if repayment becomes difficult.

The Federal Reserve Bank of Kansas City reports that a majority of lenders indicate the debt-to-income ratio of business owners as a very significant consideration when credit quality changes, more so than nearly any other indicator.

Several things feed into that number:

• Existing unsecured debt and any revolving credit balances still being paid down
• Revenue trends shown across recent bank statements and tax returns
• Cash flow consistency from month to month, not just a single strong quarter
• How new unsecured funding will shift monthly obligations once it is added

A high DTI doesn't necessarily mean a business will be turned away, but it could mean higher interest rates or more stringent credit requirements. It's also a good idea to pull business and personal credit reports prior to applying, so the borrower knows what the lender will see and can dispute any errors that could impact the application.

Calculating ROI Before You Add a New Loan Amount

It is necessary that borrowers calculate every dollar from unsecured funding against what it produces and not just what it costs to borrow. It is usually recommended that borrowers compare the total cost (including interest rates, APR, origination fee and any other hidden fees) against the expected return from whatever the loan amount would be used for.

Usually, unsecured funding is used for revenue-generating equipment, staffing that increases output, or added capacity that shortens fulfillment time. This usage tends to justify the amount that is borrowed. A borrower's loan application for this type of funding may become difficult to justify if the borrowing is purely to cover a shortfall and there is no clear path to additional revenue. The origination fee by itself (often a percentage of the whole loan amount) can silently nibble away a portion of the estimated return unless it is considered from the beginning.

Before borrowing, it is worth looking at what the funding is expected to do for the business and whether the additional revenue or savings will justify the repayment. If the numbers do not make sense once the loan payments are included, taking on more debt may not be the right option. In some cases, refinancing or consolidating existing debt may be worth considering before adding another loan.

Best Practices for Managing Business Debt and Repayment Terms

Getting unsecured funding is only one part of the process. How the business manages the repayments afterward matters just as much. Paying on time can help build a stronger credit history, while taking on repayments the business cannot comfortably manage can make its existing debt harder to deal with.

• Match repayment terms to the business cash flow cycle, not just the lowest advertised monthly payment.
• Avoid stacking several unsecured business loan products at once, since each new balance raises DTI fast.
• Watch credit utilization across business credit cards and any revolving credit lines closely.
• Check credit score and credit report with the major credit bureaus before applying, so nothing surprises the lender either.
• Consider debt consolidation when juggling several high-rate balances rather than adding another one on top.
• Ask every lender to disclose fixed monthly installments and total repayment cost upfront, not just the headline rate.

None of these steps are complicated on their own. The difficulty is doing all of them consistently, especially once a business carries more than one loan or line of credit at a time. A missed payment on installment loans or a maxed-out credit limit can undo months of careful planning.

Conclusion

Unsecured funding gives small business owners access to money without requiring an asset as collateral, but the cost and repayment still need to make sense for the business. Looking at the debt-to-income ratio and expected ROI before borrowing can help an owner understand whether the business can comfortably manage the payments and whether taking on the debt is actually worth it.

There is a range of options when it comes to unsecured business loans including short term unsecured business loans and revolving lines of credit, and they are suited for different business needs. They do not eliminate the fundamental discipline of matching the loan to a real requirement and making sure that the numbers work prior to signing. A clear lending relationship with clear terms of repayment and no hidden fees helps that discipline to be sustained over the long run.