When it comes to exploring various financing options, whether you sell products, services or delectable brews from a celebrated microbrewery, one of the most important distinctions that your business must make is between an unsecured and secured working capital loan. Below, we highlight the basics of each so that you can move forward towards a smart and strategic decision.
Secured Working Capital Loans
Essentially, a secured working capital loan is backed (or “secured”) by collateral in the event of a default. There are various types of collateral, including real estate, equipment, vehicles, and in some cases, personal assets as well. Each lender has its own approach, definitions, and criterion.
The biggest advantage of a secured working capital loan is that they are generally available at lower rates compared to an unsecured working capital loan (which we will explore shortly). Furthermore, most conventional lenders and virtually all banks will only offer secured loans. There is no unsecured option available, and an application that does not have sufficient collateral listed will be rejected.
However, there are some substantial risks associated with secured working capital loans that you may find problematic or unacceptable. The first is that you risk losing a valuable asset in the event of a default. Second, lenders are notorious for undervaluing collateral, since it is in their interest to do so. Third, an asset that is listed as collateral cannot be sold during the life of the loan, unless it is replaced by another asset – which is a process that is time consuming and typically involves additional administrative fees. Furthermore, there is no guarantee that a lender will agree to accept a replacement asset, or that they will give it the same value (i.e. they may give it a lower value, thus requiring new assets to be added to the collateral list).
Unsecured Working Capital Loans
As the term suggests, an unsecured working capital loan is not backed by collateral to ensure repayment obligations. Of course, this does not mean that repayment is optional, or that you can arbitrarily change the terms and conditions. It simply means that you do not have to pledge assets (business and/or personal) to have your loan application assessed and potentially approved.
Obviously, the most compelling advantage of an unsecured working capital loan is that there is no need to pledge assets as security. There is also no risk that assets will be undervalued, and the approval process is typically faster (some banks can take weeks to evaluate assets pledged as collateral).
The drawback of an unsecured loan is that the rates are generally higher vs. a secured option. However, this disadvantage is somewhat mitigated by the fact that some lenders who offer this kind of business financing will allow you to pay your loan back early if you wish, without incurring additional fees or interest.
What’s Right for You?
Naturally, it is beyond the scope of this article to definitively advise you on which option is better for your business: a secured working capital loan, or an unsecured working capital loan. However, it can be said without hesitation that the smartest and safest thing you can do is conduct due diligence, ask as many questions as necessary, and get all of the facts you need before making a decision – not after. That way, you will ensure that your business financing choice is rewarding, rather than regrettable.