Protecting Your Assets: Why Small Businesses Prefer Unsecured Lending Over Secured Loans

What Is Unsecured Lending?

Unsecured lending refers to financing options that don't require borrowers to pledge collateral. In the consumer space, these can include an unsecured personal loan, credit card, or student loans.

For businesses, unsecured lending can refer to unsecured term loans, credit cards, or lines of credit. Borrowers can apply for these unsecured lending options without putting certain assets at risk. Because there is no collateral to back the loan, they're often considered riskier than secured loans.

As a result, unsecured loans may carry higher interest rates as well as shorter repayment terms to account for that added risk. Instead of evaluating physical assets that serve as collateral, lenders typically look at a borrower’s credit history, revenue, and cash flow.

Secured vs. Unsecured Lending: What’s the Difference?

When comparing secured vs. unsecured loans, the main difference is collateral. Secured loans use collateral, or a type of asset, to back the loan. Unsecured loans don't have any collateral backing the loan.

Business owners may use equipment, real estate, or other business assets as collateral.

Common types of secured loans include auto loans and mortgages, which are backed by the vehicle and home, respectively.

Secured loans may come with better terms and rates, as borrowers share some of the risk with the lender. If a borrower fails to repay the loan, the lender may have the right to seize the collateral. This can help reduce some of the risk and can help recover some of the costs. The exact way or time lenders may do this depends on your specific loan agreement, state, and type of collateral.

Unsecured loans don't have collateral backing them, which can be easier for the borrowers but riskier for the lender.

Borrowers can apply for unsecured lending options and obtain funds without putting an asset at risk. In this situation, lenders absorb more of the risk, so unsecured loans generally have higher interest rates. In certain cases, borrowers may be offered lower loan amounts and shorter repayment terms as well.

Why Small Business Owners Choose Unsecured Lending Options

Small business owners may choose unsecured lending options for a range of reasons, including the following.

Avoid Putting Business Assets at Risk

Running a business is already a risky endeavor. Small business owners may not want to add to that risk and pledge business assets to obtain a loan.

Keeping them completely separate can be a prudent move and offer more psychological comfort knowing that a key asset isn't on the line.

This is especially important for businesses that rely on equipment, vehicles, or commercial property for their daily operations.

Maintain Flexibility

Business owners who want maximum flexibility may not want to tie up their assets to a loan if they don’t have to. Having assets available can potentially open up more options later or work better under a different loan agreement.

For example, assets can be sold at a later date or used as collateral in the future as part of another financing arrangement.

No or Limited Collateral

Collateral may help borrowers secure more favorable interest rates and loan terms. That may also include higher borrowing limits, leading to bigger lump sums. However, not all businesses have collateral available to pledge.

Startups just getting off the ground may not have an asset available. This can also be true for more service-based businesses. For example, consultants, digital marketing agencies, or SaaS companies may have few physical assets.

Instead, they earn revenue through their expertise or work on a subscription model. In these situations, having no or limited collateral can push businesses toward unsecured lending options.

Use Different Underwriting Criteria

Small business owners may choose unsecured lending options because they want financing based on their business performance and not collateral. Lenders often look at revenue and cash flow to determine eligibility for this type of financing.

If your company has strong revenue, solid cash flow, and consistent transactions, it can help demonstrate your repayment capacity.

Modern underwriting can review financial data quickly and determine eligibility, instead of relying heavily on physical collateral.

How Fintech Lenders Evaluate Eligibility for Unsecured Lending

With secured lending, many banks, credit unions, and alternative lenders place a major emphasis on collateral. As an asset, the collateral backs the loan and provides additional protection for the lender. If the borrower doesn’t meet their repayment obligations, the lender may be able to recoup costs and seize the collateral.

But with unsecured lending, there is no form of collateral for lenders to go after. Instead, many fintech lenders use automated underwriting and data-driven practices to evaluate business performance.

Instead of focusing on collateral, online or fintech lenders may examine:

• Annual revenue
• Cash flow patterns
• Debt service coverage ratio (DSCR)/debt-to-income ratio (DTI)
• Personal credit score

• Business credit score

• Time in business
• Industry experience
• Industry risk
• Transaction history
• Average bank balances
• Average monthly deposits

This financial data helps lenders examine your ability to repay your unsecured debt. Many fintech lenders leverage automated technology to analyze this information very quickly, which can speed up both approval and funding timelines.

It’s important to note that approval and funding timelines vary by lender and the type of loan.

What to Consider Before You Get an Unsecured Loan

 As a business owner, you might decide that it makes more sense to apply for an unsecured loan rather than a secured loan.

You might not have collateral or simply don’t want to put the assets you do have at risk. While unsecured lending can make sense, there are some key factors to consider:

• Cost: Review the total cost of the unsecured loan, not just the interest rate. Consider origination or other administrative fees, late fees, and prepayment

• Loan payments: Calculate potential monthly payments based on your loan amount and Annual Percentage Rate (APR). Check them against your budget and ensure you can comfortably afford the payments.

• Personal guarantee: Unsecured lending doesn’t mean risk-free simply because there’s no collateral. Many lenders may ask borrowers for a personal guarantee, which essentially puts them on the hook for the loan if they default.

• Repayment terms: Know exactly how long you have to repay the unsecured loan and how that will impact your monthly payments and the total interest charges.

• Business needs: An unsecured loan can help with working capital or the next stage of growth. It must solve a specific problem and address one of your core needs. Make sure you’re clear on the loan’s purpose and how the investment will pay off.

• Loan amount: Check lenders’ minimum as well as maximum loan amounts. Identify the amount you need, with a small buffer, to avoid borrowing more than you actually need.

Considering these factors beforehand can help you avoid costly surprises and stay on track with your company’s financial health.

Final Thoughts

Many business owners turn to financing to help fund their next major project or to navigate a challenging time. Choosing between a secured loan versus an unsecured loan is a major decision and requires research and discernment.

While it's possible to be approved for better rates and terms with a secured loan, it can make sense to pursue an unsecured loan to avoid putting assets at risk.

Understanding what's at stake and knowing the pros and cons of each type of loan can help guide your decision.