According to the U.S. Small Business Administration (SBA), approximately 73% of small businesses make use of outside financing. It is also estimated that small business borrowing from banks alone totaled $600 billion, with an almost equal amount ($593 billion) provided by finance companies and private investors.Many of these loans are provided as unsecured loans to small business owners, which essentially act on the faith and credit of the borrower. Business owners can benefit greatly from this kind of lending, but there are always dangers to going beyond what a particular product is designed to do. We'll break down how unsecured loans work, and why they could be a great choice for you and your business if handled the right way.
A Brief Discussion About Unsecured Loans
Taking an unsecured loan with no collateral can make all the difference in the future of your company, as it gives you the capital you need to grow your business. If you're looking to purchase new equipment or expand your business, an extra source of capital can make these changes a lot more viable.
- While the borrower may not need to pledge company assets to secure this type of financing, lenders will usually ask for a personal guarantee from the borrower. This means that the lender can seize your personal assets in the event of default.
- Since these loans are not secured by collateral, they generally will carry a higher rate of interest compared to a secured loan.
- Loan amounts tend to be lower.
- Unsecured business loans usually require the borrower to have excellent credit.
The bottom line? Almost all businesses need capital to grow, and whether it's a corporate bond, or line of credit, unsecured loans can offer you the capital you need to help your business succeed.
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Why Unsecured Business Loans Are Difficult to Get: Lenders Simply Need the Security of Collateral
It's a hard fact of being an entrepreneur that the vast majority of new businesses fail (80%) within the first two years. That failure rate makes lending a very risky proposition and lenders are well aware of the potential of default.
To illustrate the issue more clearly let's say that 10 people came to you and asked you to loan them $10,000 each, but there was a good chance that only 2 of those borrowers would repay you. If you gave each of them 10,000 you would have loaned $100,000 in total and you were only expected to be paid-back $20,000, would you do it? Of course not, that would not make sense because there is a high probability you would lose $80,000.
Now let's say that each of those people pledged assets (like a car, equipment or stocks) worth at least $10,000 (collateral may need to be a value in excess of the loan amount) as a condition for receiving that $10,000 loan. If those same eight borrowers default, you will be able to sell their collateral to satisfy the unpaid loan.
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Small Business Loans from Banks are a Challenge
After the financial crisis of 2008, banks imposed strict requirements on business lending. As a result, by 2014 default rates on small business loans reached all-time lows of 2%. The reality is that business lending during this period slowed to a trickle and only the most highly-qualified applicants were granted credit.
According to the 2016 SBA Report on Small Business Finance:
The Kauffman Foundation found that nearly 20% of credit applicants in their business survey were denied. When businesses do receive new credit, they often do not receive the full amount applied for. According to the Federal Reserve, 82% of small employer firms were approved for financing, but only 50% received the full amount requested. Further, businesses are often discouraged from applying for additional credit due to an expectation that they will be turned down. The Federal Reserve found that 16% of small businesses felt discouraged from seeking additional credit or financing. Minority and women-owned businesses are disproportionately more likely to be in this discouraged group than their nonminority or male counterparts.
Is an Unsecured Business Loan Right For Your Company?How Companies Fund Business Growth
In seeking business financing for your company, it's helpful to understand how the majority of small businesses in the U.S. go about it.
Top 3 Sources of Expansion Capital (%)
According to the US Census Bureau and the SBA, only 5% of companies used a bank loan for expanding their business, about the same percentage (5%) used their personal credit card to fund their business. Alarmingly, 57% of companies choose not to expand their business because they either did not apply for credit or were denied credit. Most business owners used personal savings to fund their businesses.
The Biz2Credit Small Business Lending Index (SBLI) is a monthly report that tracks business lending activity. According to the SBLI, banks are still the leading source of business loans to small companies (for loans under $1 million). This report provides an analysis of the activity of the top lending sources.
Review of the Benefits and Disadvantages of Unsecured Business Loans
Benefits
- Access to cash
- No collateral requirements
Disadvantages
- Higher interest rates
- Personal guarantee
- Lower loan amounts
- Requires excellent credit
Applying for an unsecured business loan may be the only alternative for some business owners to finance expansion or business operations. However, it has limitations and as we have seen, it is rarely "unsecured" because most lenders will require a personal guarantee.
And, like a merchant cash advance, an unsecured business loan usually carries a higher rate of interest than other loan types.
Use Common Sense When Applying for an Unsecured Business Loan
A truly "unsecured business loan" is virtually non-existent.
The lending landscape can be confusing for business owners and there are undoubtedly bad actors in the loan business. Using some common sense, you can avoid getting caught by a damaging debt with exorbitant interest rates and risking losing your business or personal assets.
If you are offered an unsecured loan that looks too good to be true, it probably is. Here's what you should look for when evaluating an unsecured loan:
- What is the total interest rate? This is the annual percentage rate (APR)?
- Does the loan require a personal guarantee?
- Read the fine print! It is important to read and understand the entire document.
- Get several offers, shop around, rates can vary widely from lender-to-lender.
- Look for the terms "UCC" or "Blanket Lien" in the fine print and understand the implications.
- Check the reputation of the lender.