Unsecured business loans can be a low-risk way for startup or established businesses to obtain finance for large capital intensive projects or to fund day-to-day expenditure. Unsecured loans are so-called, because they don’t involve posting any assets of the business, or business owners, as security against the loan. However, because the lender lacks this security, interest rates on unsecured loans are often higher than on secured loans of equivalent value.
How do unsecured business loans work?
Unsecured business loans work in a similar way to personal loans. A lump sum is advanced to the business and repaid in monthly or quarterly installments over a pre-agreed time period. Interest is charged on the outstanding amount of the loan at a fixed or variable rate as per the loan agreement. Sometimes the lender will also charge a fee to arrange the loan which will be incorporated into the repayments.
As opposed to a secured loan, where some asset of the business or business owner (e.g. property) is offered as security against the loan, with a secured loan the lender may have very little recourse in the event that the business is unable to make payments. Because of this lack of security the lender will often charge a higher rate of interest on unsecured loans than on secured loans.
For the same reason, the application process and lending criteria are also often stricter with unsecured loans than with secured loans. The lender needs to be assured that the risk involved in loaning the money is appropriate to the reward.
Pros and cons of unsecured loans
The chief advantage of taking out an unsecured loan is that you don’t need to put any of the business’s, or your own, assets at risk. In the event that the business is unable to make repayments on the loan the lender has no claim on any of the business’s property.
The disadvantage of unsecured loans is that they are usually more expensive than a secured loan. The increased cost of borrowing will have a negative impact on the profitability of the business and could exacerbate any underlying financial difficulties.
Where to obtain an unsecured loan
There are many choices when it comes to obtaining an unsecured loan for business.
Unsecured loans from banks
Most high-street banks will offer medium to long term business loans in both secured and unsecured varieties. Interest rates on unsecured loans will generally be higher and the bank will often make more vigorous checks of the borrowing company’s underlying financial health (a process known as underwriting).
Since the credit-crunch unsecured lending from banks has been more difficult to come by. But, banks still offer very competitive interest rates and low arrangement fees so this route is still well worth investigating.
Unsecured loans from peer to peer lenders
Peer to peer lenders, like Funding Circle, Zopa and RateSetter, are a newer breed of business lender which almost exclusively offer unsecured loans over periods of up to 5 years. Interest rates on peer to peer loans are similar to, often in fact lower than, unsecured bank loans, but they usually come with arrangement or completion fees attached. An advantage over loans from banks is that there are very often no fees for early repayment.
Unsecured loans from specialist business lenders
There are now many companies competing with banks in the unsecured lending space, primarily offering unsecured short-term loans e.g. ezbob. The interest rates attached to these loans are often higher than with banks and peer to peer lenders, but the lending criteria is often less strict.
Unsecured loans from government schemes
The British Business Bank is a publicly owned development bank which offers loans to startup and existing businesses, enabling them to obtain unsecured loans from banks or other lenders at competitive rates. While the application process can be quite lengthy, such loans can be an excellent option for businesses who plan their borrowing well in advance.
Alternatives to unsecured business loans
Unsecured loans aren’t the only kind of finance available to businesses looking to expand or plug a temporary gap in cash flow.
Putting up a business asset as security against a loan sounds scary - in the event that the business can’t make repayments the lender will take possession of the asset. However, if there is a high level of confidence that the business will be able to service the loan then it it does provide access to lower interest rates. Also, if the loan is being taken out to purchase a particular asset then that asset itself could be used as security, minimising the overall risk to the business.
Business overdraft facility
As an alternative to a loan a business might be able to obtain an overdraft facility with its regular business bank. This form of borrowing is also unsecured and, while the interest rate on an overdraft will generally be higher than that on a loan, it could be used to fund a temporary cash flow shortage.
A revolving credit facility is similar to an overdraft, but isn’t attached to a current account. Instead it takes the form of a line of credit on, where the business only pays interest on the portion of the loan it draws down. Such facilities are available from a variety of lenders, sometimes without the arrangement fees charged by banks.
Business credit cards
Another form of unsecured lending, business credit cards can also make day-to-day purchasing easier and more transparent. Many cards come with an interest free period for balance transfers and new purchases, but interest rates overall are generally higher than with loans. There are also usually annual fees charged for each card issued.
A loan with a director’s guarantee
Startup businesses or businesses with poor credit ratings which don’t have assets to use as security against a loan might still be able to obtain unsecured lending if the directors take on personal responsibility for repaying the loan. Signing such a legal agreement to personally service a loan, which the business is unable to repay effectively waives the protection offered by limited liability status and could result in personal bankruptcy. This option should be considered carefully.