What Does Security Mean When Taking Out a Loan?
Lenders of all types are tasked with one major consideration – to balance the risk versus reward formula in any particular situation. Riskier borrowers – namely, those with lower credit scores, a history of credit issues, or those with minimal business history, will force lenders to charge higher interest rates to counteract the credit risk. Those with stellar credit files and a proven and successful business will typically be able to demand lower interest rates and fewer fees to complete the loan.
Another way that a lender can mitigate the overall risk of lending money to a borrower is to demand a security instrument, or collateral. This means that if a borrower stops making payments the lender can seize something of value from the client. Examples of collateral types are inventory, future sales, business-owned or personal real estate, or other general business assets. An unsecured loan refers to a lack of collateral. This makes most lenders nervous, as the only thing that forces a buyer to keep making payments is their signature on the loan documents.
Benefits of an Unsecured Loan Vs. Secured Loan
Unsecured business loans do not place any of your business assets in peril should a default in payment occur. That said, unsecured business loans typically have lower approval rates than secured business loans because they are riskier to the financial institution. In fact, some lenders won’t even approve an unsecured business loan anymore due to the higher default rate attributed to these types of loans.
Secured loans mean higher approval rates and lower interest rates, so why would anyone want an unsecured loan? The bottom line is that an unsecured loan does mean that none of the assets of a business are directly placed in jeopardy. This can be comforting to some and may be worth a higher interest rate. Lenders approve secured loans more readily because they represent significantly less risk to the institution.
Think about a consumer car loan – stop making payments and the bank can repossess the car and sell it to recover much of the loan amount. Secured business loans act very much the same as a traditional automotive loan. Something of value that is owned by the business is placed as collateral and acts as the “promise to pay” instrument for the loan.
Can Asset-Based Lending Combine the Best of Both Worlds?
Asset-based lending, or using future receivables as the collateral for a loan, combines the easier approval of a secured loan with the flexibility of an unsecured loan. Typically, no credit checks are required, and the interest rates are commensurate with the risk level involved. Minimal documentation is required, and the payments match the businesses actual revenue amounts. Whether considering a secured or an unsecured loan, taking a look at an asset-based loan may combine the best features of both loans to ensure that your short or long-term financial needs are met.