Getting your head around financial jargon is just one of the many challenges you will face as a business owner.
And if you’re on the hunt for credit, then secured vs unsecured loans is probably one of the many phrases you’ll find yourself typing into Google late at night, as you try to work out what is the best option to finance your growth.
But to save you some time navigating banker jargon, we’ve explained the key differences between these two types of credit below, plus we take you through some key considerations when weighing up the two options.
What’s an unsecured loan?
An unsecured loan is credit extended to you by a lender over which no security is taken. That means if your business fails to pay back the loan, the lender has no ability to force you to sell assets the business or you may personally own, in order to recover any money owing to them.
You’re probably thinking, that’s pretty risky, why would a lender offer this sort of unsecured finance? Well, every lender has a different credit policy, which is a set of rules they use to determine if your business fits the profile of companies they would be happy to lend to.
Many niche lenders that operate in certain verticals understand certain business models better than generalist lenders (like banks) and build specialist lending businesses off the back of this.
This means they can feel more comfortable taking on the higher risk associated with unsecured lending and offer a market competitive price.
Having said that, it’s highly likely you will still be assessed at a personal level, and some lenders will take your personal creditworthiness into consideration before lending you any money for business purposes.
In some cases, they may also ask for a personal guarantee from a director. Remember, if this is you, then it does mean you are personally liable if the business fails to meet their repayments. Always read the fine print!
What is a secured loan?
A bank or non-bank lender will offer you cheaper business credit if you have an asset you are willing to back your loan agreement with. In the industry, this asset is often termed as ‘collateral’ and forms the foundation of a secured loan.
In this scenario, you are entering into a contract that gives the lender the power to take and sell the asset you put up as collateral should you not be able to make your loan repayments.
Because this ensures the lender has a much better chance of recovering money owed to them, they are comfortable to lend to you at a lower rate than in an unsecured scenario.
Depending on the credit policy of the lender, collateral that might be considered could be an owned commercial premise, machinery and equipment, investments or future payments from customers receivables.
However for many small business owners, the collateral most often in demand is the family home.
When this is the case, if multiple directors are involved in a business it can be difficult to agree upon who should take on that risk, and how they should be compensated for doing it.
In some instances risk can be spread, however it’s important to remember that if things do go belly up, the director with the deepest pockets could be the last person left standing to shoulder the burden of the debt.
So when taking on a secured loan in a multiple director situation, legal advice is a worthwhile upfront investment.
How to choose between the two?
If you’re in a position where you have assets and you can choose, consider yourself fortunate! Many young business owners just starting out often don’t have assets they are able to use to access secured finance, and are forced to take up unsecured loans or use personal loans and credit cards.
Choosing based on price is where most people begin. Lenders invariably charge more for unsecured loans, to compensate for the higher risk they take on. The best analogy from personal lending is a credit card versus a home loan. A credit card is unsecured personal lending and can cost you upwards of 20 percent per annum, while a mortgage, which is secured against your home, can have rates as low as 3 or 4 percent.
But while the price is an important factor, the risk you and your business assume as part of a secured lending contract should also be taken into consideration. Sometimes access to unsecured finance, while slightly more expensive, is a better option than using collateral to get a slightly better price.
These sorts of decisions reflect your own attitudes towards risk and often the relationship you may have with other business partners. And with more and more niche lenders coming on the market, unsecured finance is starting to become a more financially feasible option as well.
If you’re ready for a more in-depth discussion on which type of loan is right for your business then contact the team at Octet today.