Why Unsecured Loans Pose Risks For Lenders And Borrowers
Times can be tough and business owners of all shapes and sizes will at some point find themselves in need of a loan. Even if the company’s cash flow and outlook point to a quick repayment timeline, unsecured business loans can still keep many entrepreneurs awake at night while lenders are just as worried about the ability to recoup their funds.
Unsecured Business Loans Versus Secured Business Loan
Business owners that need access to capital to fund their operations for a short-term period or longer-term timeline can do so by taking a loan. Typically, there are two types of business loans that are available to entrepreneurs.
The first is a secured business loan. As the name suggests, the majority if not all of the value of the loan is secured through placing assets as collateral. For example, a maker of gym equipment could secure a $300,000 loan by offering $300,000 of its finished goods (i.e treadmills, weights, etc.) as collateral.
If the company fails to abide by the terms of the small business loan, the lender could obtain legal authority to seize the property. While the lender likely has zero experience in reselling gym equipment, it will gain ownership of assets that can at the very least be included in the balance sheet. Even if the lender outsources the selling process to a third party, it could recoup the majority of the amount owed, say $275,000 in cash.
By contrast, an unsecured business lender offers loans to qualifying businesses that cannot or will not place assets as collateral. If the borrower fails to repay the debt, the lender’s potential losses could be as high as 100%.
Sure, the lender will likely take legal action to recoup its cash through seizing assets, it risks entering into a prolonged court battle with an uncertain outcome.
Unsecured Business Loans Carry Higher Rates, Lower Approval Amounts
Lenders prefer secured business loans over unsecured business loans and this reality is reflected in the interest rate terms and approval amounts attached to the loans.
Entrepreneurs that accept unsecured business loans will do so knowing they are paying a premium interest rate. Perhaps they have no other option but to do so, but this is irrelevant.
In these trying times amid the ongoing global COVID-19 pandemic, business owners need to do all they can to keep costs low. The benefit of this is the company can pass along savings to consumers while keeping as many workers on the payroll as possible.
Moving on to the actual approval amount, many business owners wake up one morning to a confirmation from the lender that the loan was approved, but only for a fraction of the amount requested.
In many cases, approval for half the amount requested is just as useful as being declined. If a business needs to borrow $200,000 to pay a supplier and they receive access to just $100,000 from the unsecured business lender, there is no benefit to the owner.
This isn’t to say that lenders are acting in bad faith. Rather, they have a duty in protecting their own assets first and foremost. This practice will vary on a case-by-case basis. If an unsecured business lender has conducted multiple transactions with a borrower over the years, they might feel more comfortable in bending their own internal practices to keep a long-term customer happy.
But a new borrower with inadequate assets to place as collateral? Full is looking unlikely.
Alternative Option To Unsecured Business Loans: Unsecured Line Of Credit
There is no one size fits all approach towards borrowing money, especially from an unsecured business lender. In some cases, an unsecured business loan is an ideal venue to raise capital while in other cases not so much.
Other alternative methods of obtaining financing include a somewhat similar tool called an unsecured business line of credit. Much like a personal line of credit, an unsecured business lender gives an entrepreneur access to a set amount of cash that can be used over time. Whatever is repaid to the line of credit will become instantly available to the entrepreneur again so there is no need to re-apply.
For example, an entrepreneur decides an unsecured business loan is a better option than an unsecured business loan. They are approved for a $100,000 line of credit, of which $25,000 is used right away to finance new equipment.
The entrepreneur now has access to the remaining $75,000 and if they pay back $5,000 towards the line of credit they will have access to borrow $80,000 in capital.
The entrepreneur does not need to use the entire amount of the line of credit at once. This gives some additional flexibility as the interest charges in most cases will be based on the amount drawn from the line of credit, rather than the total approved amount.
Other less recommended options for businesses to obtain financing include using a business credit card or even a personal credit card. Granted, if the credit card bill can be paid in full and on time, then the business owner essentially gets to borrow money for free and could earn a few percentage points back in the form of reward points.
But if the borrower is unable to pay back in full and on time, the interest rate will likely be much higher than an unsecured business loan.
Conclusion: Unsecured Business Loans Is Risky For Everyone
Both sides of the lending transaction face a good amount of risk and uncertainty. On one end, the unsecured business lender has no guarantee they will be able to recoup their funds in the event of default.
On the other side of the transaction, the borrower faces higher interest rates and may not even get approved for the full amount required.
But such is the nature of the unsecured business lender’s model. The two sides transacting with unsecured business loans agree to interact with each other under predefined conditions and everyone hopes for and plans for the ideal outcome while thinking about how to deal with the worst-case scenario.