For many entrepreneurs, a small business loan is the best way to finance a new business or grow an existing organization. However, obtaining a business loan can be difficult for startups and small companies because the risk to financial institutions is greater than lending to larger businesses.
If you’ve begun to explore commercial lending options, you may have noticed some banks offer “secured” loans with more attractive interest rates and payment terms.
To help you determine if you’re eligible for a secured business loan — and whether it’s the right choice for your financial situation — here’s what you need to know.
Secured vs. unsecured business loans
Any commercial lender takes on a significant amount of risk in offering a loan because there’s always the possibility that a business will fail and be unable to make payments. The main difference between a secured and an unsecured loan is the way a lender mitigates that risk.
A secured business loan requires a specific piece of collateral, such as a business vehicle or commercial property, which the lender can claim if you fail to repay your loan. These types of loans are often easier to obtain and may come with lower interest rates because the lender has a guaranteed way to get their money back. They can recoup their losses by selling your collateral in the event of a default.
Unsecured loans, on the other hand, are not attached to any collateral. Personal loans, student loans, and credit cards are common examples of unsecured loans. These types of loans often come with high interest rates and stringent approval requirements to ensure the lender gets their money back.
Personal guarantees and blanket liens
Because of the increased risk to the lender with an unsecured loan, they may ask you to sign a personal guarantee to approve it. This means that, if your business defaults on the loan, you are personally liable for repaying it.
While a creditor can’t seize your business property under a personal guarantee, they can legally claim your personal assets, such as bank accounts, cars, and real estate, until the loan is repaid.
Another common method of mitigating lending risk is by reserving the right to file a blanket lien over your business assets. According to Fundera, most business loan terms include a blanket lien clause that allows the lender to claim and resell your business assets to collect on your debt.
While many entrepreneurs use their business assets as collateral, it is also possible to use your personal assets to secure a loan.
How do secured business loans work?
The Balance explains that the amount of money you can borrow against collateral depends on the loan-to-value (LTV) ratio offered by your lender.
For instance, if your collateral is worth $100,000 and the lender allows for a 75% LTV ratio, they can lend you a maximum of $75,000.
Keep in mind that if your pledged assets lose value, you may be required to pledge additional assets to maintain a secured loan. Additionally, if your lender takes your assets and sells them for less than the amount you owe, you are responsible to make up the difference.
There are several types of collateral you can use to obtain a secured loan. In fact, any asset a lender feels holds significant value can be used as collateral, including some surprising items. However, the most common types of collateral include:
- Real estate
- Vehicles
- Machinery and equipment
- Accounts receivable
- Investments
- Bank accounts
- Insurance policies
While many entrepreneurs use their business assets as collateral, it is also possible to use your personal assets to secure a loan.
Types of secured business loans
Here are a few types of secured business loans.
Term loans
Term loans usually require collateral and have a set repayment schedule and a fixed or floating interest rate. The amount of collateral used and the borrower’s current credit score can determine the amount the financial institution will approve for the loan. While terms can vary, a term loan generally ranges from one to 20 years for repayment and can range in coverage from $25,000 to $500,000. Term interest rates tend to range between 5% to 25%. Business owners can use term loans to cover a wide variety of business expenses.
SBA loans
U.S. Small Business Administration (SBA) loans are another example of secured business loans. Three of the most popular loan programs — the CDC/504, a microloan, and a 7(a) loan — are SBA loans. An appealing aspect of an SBA loan is the lower interest rates. Rates will vary depending on the agreement with the lender but typically range from 4% to 13% interest, and terms can vary from five to 25 years. The 7(a) loan program offers up to $5 million.
Business lines of credit
A business line of credit works like a credit card. You have access to the funds and can withdraw as needed, paying interest only on the funds used. They can range from $10,000 to $1 million. The repayment schedule depends on your lender, and you can expect to pay anywhere from 7% to 25% in interest.
Equipment financing
This loan specifically finances the equipment needed for your business, and the loan amount can only be for up to the cost of the equipment. The terms typically match the length of the expected lifespan of the equipment the loan is funding. Interest ranges between 4% and 40%, depending on your credit and how new your business is.
Invoice financing
Invoice financing uses outstanding invoices as collateral to guarantee the loan. This can benefit companies that experience a delay in payment from clients, since it provides the funds instantly through the loan. Often, lenders advance up to 85% of the invoices used for collateral. Lenders keep the remaining 15% in reserve and release it on a schedule and rate based on when the borrowing business receives payment for its invoices.
Inventory financing
This is a self-secured loan, similar to equipment and invoice financing. Inventory financing does not use personal assets to secure the loan. There are various types of inventory financing loans, such as a medium-term loan, a line-of-credit loan, and a short-term loan. You receive an advanced sum from the lender you'll use to buy inventory. If the inventory does not sell, then it is used as collateral for the lender to sell to recoup the loan amount.
Pros and cons of secured business loans
Borrowing money always comes with risks, and you should always be wary of falling into a debt trap. Before considering a loan, evaluate your business and make sure you will be able to pay off the loan or, at the very least, the interest on the money you borrow.
However, secured loans do come with some significant advantages over unsecured loans. Here are the pros and cons of secured business loans:
Pros
- Lower interest rates. Secured loans are less risky to the lender, as they come with collateral. If you have a steady income, valuable assets, and good credit history, you can shop around for the lowest rates.
- Bigger loan amounts. Generally speaking, you can obtain a much higher loan amount through a secured loan, as the lender assumes less risk. The more valuable your collateral is and the easier it is to access, the larger the loan amount.
- Longer repayment periods. Secured loans usually come with better repayment terms, allowing borrowers to pay off the loan over several years. Home loans, for example, are often repaid over 30 years.
- Easier to obtain with poor credit. If you have a poor credit history, an unsecured loan may be virtually impossible to obtain until you spend months or years rebuilding your credit. Since secured loans rely on collateral, lenders are more willing to offer a loan.
Cons
- Potential loss of assets. The biggest downside to a secured loan is that the lender can seize an expensive, valuable business asset if you default. If you’ve invested a lot of money in that asset and have built up equity, you can lose it all instantly if the lender claims that property.
- Credit damage. Defaulting on any loan can significantly damage your credit and your ability to borrow in the future. If you hit a rough patch, some lenders will help you avoid default, as it’s sometimes easier to assist during a temporary lapse than it is to collect and sell the collateral.
Is a secured business loan right for you?
If your business doesn’t have much in the way of assets, you might not be eligible for a secured business loan.
However, if your business has a valuable asset that could be put up as collateral and you are confident about your ability to repay the loan, a secured loan is your best option for good loan terms and an easy approval process.
According to National Business Capital and Services, you should ask yourself the following questions before you apply for a secured business loan:
- Which assets do you feel comfortable leveraging?
- What kind of repayment terms are you looking for?
- How much do you need to borrow?
- What are you going to use the money for?
How to get a secured business loan
Get your finances in check
To help secure a loan for your business, start by checking your eligibility. Review your credit score and credit history before starting the loan process, since this largely factors into the loan’s approval, rates, and terms.
Compare different loan types
Determine your business’s specific loan needs, and educate yourself on how each loan works and what the repayment details are. Additionally, consider factors like collateral, loan amount, and interest rates. Have realistic expectations about what you can offer upfront for collateral and for your repayment schedule.
Research your lender
It is important to take your time when comparing and researching your options. Check online as well as at local financial institutions. Make sure your chosen lender comes well recommended and is transparent about every step of the process. Compare terms and rates for the loan you want with different lenders to see where you can get the best deal.
Organize your documents and fill out your application
Create, find, and gather all the necessary documentation into a single folder for the application before you start the process.
Once you fill out a formal application form, do not rush the paperwork and signing process with the lender. If there is any part of the process you don’t understand, ask questions. Be meticulous, as mistakes can result in being approved for a lower amount or even being denied. Fully understand the expectations of the loan agreement before signing.
[Read more: Everything You Need to Know to Prepare to Apply for a Business Loan]
If you’re ready to start talking to lenders, our guide on preparing to apply for a business loan can help.
This story was updated by Kirsten Capunay and Sean Peek.
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