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Unsecured Business Loans: How Do They Work?

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Unsecured loans allow you to borrow money without risking any assets. Are they worth the steep price? Read on to learn more about unsecured loans.

I have worked in a client facing role in commercial credit sales for a number of years. I’ve grappled with a common refrain among older business owners: “Why can’t you just do that with my signature?”

For decades, banks have made loans to borrowers who have had a longstanding relationship with them. The loans would be settled in one day and the borrower would have the money based only on their guarantee.

Modern banks make the search for a small business loan much more difficult. Hundreds of bank failures and thousands of new regulations have made it significantly more difficult for banks to lend money in high-risk situations. Despite this, you may still be able to get an unsecured business loan. Here’s how.

Overview: What are unsecured business loans?

Unsecured business financing is when a business can get a loan without posting any collateral. Most business loans are made for a direct purpose (e.g. real estate or equipment) and the loan is secured by that purpose. This means you cannot sell the equipment or real estate without first paying off the loan, and if you default on the loan, the bank will take back and sell the collateral to reduce the loan balance.

Unsecured corporate loans are generally for working capital and are rarely large enough to purchase real estate or a significant amount of equipment.

How do unsecured business loans work?

If you do manage to get an unsecured business loan from a bank (not easy), you will likely have to personally vouch for the loan. This means if your company defaults on the loan, there is no collateral to withdraw and the bank will come after you to pay the balance. If you get the loan from an online lender or a credit card company, you may not have to personally vouch for it.

Unsecured loans almost always have higher fees and interest rates; Even government-guaranteed microloans can have interest rates in the mid-teens.

4 Types of Unsecured Business Loans

Here are four common types of unsecured small business loans.

1st SBA

SBA loans under $150,000 do not require collateral. Between $150,000 and $350,000, the bank must “seek additional collateral,” but if it’s there, the deal can still go unsecured.

In both cases, the bank makes a general UCC registration for the deal. UCC stands for Uniform Commercial Code and is how states register collateral for items such as accounts receivable and equipment. You can think of it like the title of a vehicle or property.

The general UCC means the bank will grab any assets you have that have no prior liens. These are usually things like desks, computers, and inventory. This means that the loan is not technically unsecured but is a kind of purgatory for business loans. You are free to do with your assets and sell them if you wish, but the bank will take 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 good relationship with your bank, you may be able to avail 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 you would for SBA loans.

I was in a store for months getting an SBA export credit line for a company that was buying cornmeal in 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 first on our UCC filing.

Turns out the borrower had obtained what he believed to be an unsecured $25,000 line of credit from a major bank during underwriting to help make ends meet until we got SBA approval. The big bank secured its loan with a UCC application and was now in first place. The borrower bought $80,000 in cornmeal and had to be reimbursed to make his own mortgage payment, but he was technically in arrears on the export loan.

We had to have a conventional emergency loan approved until he was able to close the “unsecured” line of credit and remove the UCC. Unsurprisingly, the big bank took its time. Make sure you 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 every loan amount in potential credit cards to try to sell to customers.

Credit cards are also the most expensive of these options. They have sky-high interest rates and often an annual fee. If you use them, stick to the general running costs and pay off the balance monthly.

4. Merchant Cash Advance

The reason banks force credit cards on their customers is because of the high interest rates and hefty merchant fees. Every time you use a credit card, the business owner has to pay a merchant fee to process the transaction. Merchant Services may be provided through your bank or a third party.

Some merchant service providers allow you to make a merchant cash advance. This is like a small business payday loan. The trading services company knows how much you make in credit card transactions and guarantees the transaction based on those inflows.

After receiving the advance, the balance will be paid out slowly if you accept credit card purchases. As you probably expected, cash advances at merchants have fairly high fees. Only use them as a last resort.

Should You Use an Unsecured Business Loan to Fund Your Business?

Here are a few pros and cons of unsecured business loans.

3 advantages of unsecured business loans

Unsecured business loans can offer some attractive benefits.

1. Releases collateral

The main advantage of unsecured business financing is that you are free to use your assets as you see fit. If you need to sell equipment to enter a new line of business, you can. If you need to account for your receivables to speed up your cash conversion cycle, you can. If you’re having a big month and your inventory is sold out, you don’t have to worry about that.

2. Speeds up the approval process

A large part of the underwriting time for real estate and equipment loans is evaluating the collateral. A large portion of the time that is spent each month keeping revolving credit lines open is reporting the credit base to the bank. For unsecured loans, skip this step.

Additionally, many modern lenders use an algorithm to rate and approve unsecured loans because they are smaller than a typical real estate or equipment loan. This makes the process much easier and faster.

3. Reduces risk

The ability to sell your collateral when you want isn’t the only benefit of not using it to secure a loan. You can also use the collateral to continue the business if you default on the loan. This gives you an opportunity to turn back and eventually repay the lender.

3 Disadvantages of Unsecured Business Loans

However, unsecured business loans also have their pitfalls.

1. Interest Rates

In the financial world, there is a clear connection between risk and interest rate. Lenders who are unable to collect collateral must be compensated for this risk. If you get an unsecured line of credit or credit card, make sure the balance stays at $0 as much as possible.

2. Fees

Lenders know that high interest rates are unattractive and will seek to lower interest rates and compensate by charging for things like closing costs, line usage, line non-usage, document preparation, business plan preparation, or executive bonuses.

Keep track of your loan documents and make sure you go through all loan uses. Sometimes the lender pays their fees with the loan, so you don’t start with a $0 balance, but you don’t have to put up cash for the fees either.

3. Discipline

I worked with a cranky old man (as he would proudly have called himself) experienced from decades of working with high-risk companies. He was in the SBA department and often wanted collateral on loans that technically weren’t required to impose discipline on the borrower.

If a borrower has to pledge a second lien on their home to get a loan, or has to report a credit history each month to maintain access to a revolving line of credit, they’re far more likely to pay off the loan on time.

This discipline is a good thing when running a business. The risk of losing important assets or the need to support a credit base helps ensure you are not living beyond your means. An unsecured loan does not impose any discipline on your business as there is no direct risk to your assets if you default.

Should You Secure an Unsecured Loan?

Unsecured loans seem ideal at first glance. You get the money without the risk of losing anything. In reality, most successful small businesses don’t use unsecured loans much because of the cost. Unsecured loans are a cut above loans from Small Business Investment Companies (SBICs) or mezzanine funds and are often the last gasp of a failed business.

Richard Dement

The author Richard Dement