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- Secured loans can be issued for either business or personal use and are issued when some kind of collateral is produced to the lenders. This collateral is even more necessary if the borrowed amount is too large or if the creditworthiness of the borrower is not satisfactory.
- An unsecured loan is, in many ways, the opposite of a secured loan and does not require any kind of collateral. This kind of loan relies completely on the credit score of the borrower and one must have a very high credit score to be approved for an unsecured loan.
- The benefits of secured loans include a low interest rate, sizable loan amounts, comfortable loan terms, and opportunities for building a good credit score.
- The benefits of unsecured loans include a collateral-free arrangement, reduced scrutiny, fast funding processes, credit-based loan size, little to no restriction of usage, and better long-term relationships.
- Risks for secured loans include a potential threat to assets and damage to credit.
- Limitations of unsecured loans include the increased potential for smaller-sized loans and reduced repayment time periods.
- Some platforms for secured loans include TD Bank, PNC Bank, People’s United Bank, Coastal Credit Union, America First Credit Bank, and CitiBank.
- Some platforms for unsecured loans are TD Bank, Bank of America, Blue Vine, Fundbox, and Ondeck.
What are Secured and Unsecured Loans?
What is a Secured Loan?
If you are looking for financing for your startup, secured loans can be issued for either business (or personal) use and are issued when some kind of collateral is produced to the lenders. This collateral is even more necessary if the amount to be borrowed is too large or if the creditworthiness of the borrower is not satisfactory. Secured loans generally carry low interest rates as the risk to lenders is reduced drastically. However, the interest rates may be higher for individuals with bad credit scores.
The collateral which is placed with the lender can take many forms. Sometimes, the collateral that is offered is the asset that the secured loan would be used to buy. The best example for this is a piece of equipment for your startup, in which the equipment that will be purchased is used as collateral to qualify for the loan. In case you are unable to repay your loan on time, the bank or lender can seize your collateral and auction it off to repay the money that you owe on the loan.
What is an Unsecured Loan?
An unsecured loan is, in many ways, the opposite of a secured loan and does not require any kind of collateral. This kind of loan relies completely on the credit score of the borrower (you, the founder) and one must have a very high credit score to be approved. Sometimes, if a borrower is not able to meet the credit score requirement of the lender, they are allowed a cosigner. Perhaps this could be a co-founder, relative, or well-heeled business associate. The cosigner is legally obligated to pay the debt to the lender in case you (the original borrower) fail to do so. Since you have not promised any kind of collateral to the bank, they cannot repossess anything that you may have used the borrowed money for.
However, there are other steps that they can take.
For example, the lender can hire a debt collection agency to collect the overdue debt. Another option is to take legal action against you. If the bank wins, then your wages will be garnished and a chunk of your take-home pay will be sent to the bank. In other situations, a lien may be placed on any property you own. Failure to pay the loan on time can have consequences like a lower credit score, which will affect the interest rates of future loans. You may also not be able to qualify for an unsecured loan in the future.
Benefits of Secured Loans
Before opting for one of these loans, you must have an understanding of which suits your startup better.
Here, we will look at some of the benefits of secured loans:
Banks/lenders rely on collateral provided by the borrower for issuing a secured loan. As there is an assurance of some type of repayment, the bank’s risk reduces significantly. Therefore, the interest rates on secured loans are relatively low. There could be instances where organizations will approach you and offer secured loans. This tends to happen to individuals with a steady income, valuable collateral, and strong credit history. Your startup could look attractive to potential lenders, especially if it's surpassed the crucial early stage.
Along with having reduced interest rates, the amount of a secured loan can be quite substantial.
The reason for such size is the reduction of risk. As the lender has certain collateral, even if you default on the loan, they tend to make back their money. Therefore, they do not flinch from clearing large loans. Keep in mind, though, that the value of the loan will be proportional to your collateral.
The terms of repayment for secured loans are generally more relaxed than the terms for unsecured loans. Lenders generally allow borrowers a longer time for paying back the loan. This will depend on the type of loan, the amount, and the terms set by the lender.
Beneficial to building credit
If you completely pay your secured loans within the stipulated time, then it will enhance your credit score. This will help reduce the interest rates of loans that you may opt for in the future.
Benefits of Unsecured Loans
The following are some of the advantages of unsecured loans:
Unsecured loans are a great source of funding for your startup as they do not require any form of collateral. In case your startup doesn’t perform as expected, there is no risk of losing any asset.
Unsecured loans require less scrutiny of your assets and business. At most, you will be asked to produce a financial statement of the previous 6-12 months and a Social Security number. As long as you meet the lender’s criteria, a loan should be issued without any problem.
Since the documentation process of unsecured loans is not very extensive, funds can be released quickly.
Credit-based loan size
In the case of unsecured loans, the size of the loan amount is dependent on the credit score of an individual. Therefore, if you have maintained a good credit score, then you may be eligible for a relatively hefty loan.
No restriction of usage
Lenders do not excessively ponder the use of funds when it comes to unsecured loans. Therefore, you have more freedom to use the issued amount however you like. The banks don’t fret too much over the usage as long as the payments are made on time.
Better long-term relationship
For founders of startups and other small businesses, it is recommended to organize a strong network of institutions around you. If you pay off your loans on time, then you will be able to create a favorable reputation among lenders along with an impressive credit score. This will help you in procuring future loans more smoothly.
Interest Rates for Secured and Unsecured Loans
The interest rate of any loan can depend on various factors. Mathematically, the interest rate is proportional to the principal amount. However, the main factor on which the interest rate of a loan is based is the total risk taken by a lender.
In the case of secured loans, you will sign off some assets to the bank (or lender) in their contract. This means that if you default on your loan, then the bank can seize your assets and sell them to make up for the money lost. Due to this security, the interest rate on secured loans tends to be lower.
On the other hand, unsecured loans do not involve the lenders taking any collateral. This certainly causes the risk of nonpayment to the lender to increase. Therefore, unsecured loans are generally issued at higher interest rates.
Risks for Secured and Unsecured Loans
There are vast differences between secured and unsecured loans. Therefore, each type of loan has its own limitations and risks. That's why it's important for you to be aware of them when seeking the best type of financing for your startup.
Limitations of Secured Loans
While there are many benefits of secured loans, they come with a few shortcomings.
Here are some cons associated with secured loans:
Threat to Assets
The most concerning limitation of using secured loans is the ever-impending threat to your collateral. In case you are not able to make the payments within the stipulated time, then you are in danger of losing the assets you have staked as collateral. While this may not be a particularly distressing concern when the collateral is small, it gets quite worrisome if you have something as valuable as your house or business on the line.
Specified Use Only
Secured loans can only be used for the task that has been specified by the borrower. Only home equity loans are exempted from following this rule to a T.
Limitations of Unsecured Loans
The following are some of the limitations that founders may face with unsecured loans:
Increased Potential for Smaller-sized Loans
As there is no collateral involved, the amount of money you gain through an unsecured loan will depend on your creditworthiness. If you have bad credit, then the lender will not have much confidence in providing you with a sizable amount of money.
Reduced Max Term
As there is an increased risk to lenders of unsecured loans, the period to pay back unsecured loans is significantly less than that of secured loans. At most, a borrower is given 5 -7 years to pay off a loan.
Qualification for Secured and Unsecured Loans
Qualifications for loans generally vary based on the type of bank or lender that you approach, along with the proposed use and size of the loan. However, there is a standard format of eligibility used by most banks which a founder must be aware of.
Eligibility criteria for secured loans
- Applicants are required to be over the age of 18 to qualify for a loan.
- They must be a resident of the USA.
- To be considered for a loan, you should make a minimum predetermined income per annum which may differ between banks. The lender will look at your source(s) of income.
- When considering business income, your startup should have been active and generating profit for 3 years or more.
- Finally, you must have assets worth as much as -- or more than -- the value of the loan they are applying for.
- Documentation must also be produced, such as proof of nationality and financial statements to verify all the above-mentioned criteria
Eligibility criteria for an unsecured loan
- The applicant must be above the age of 21 and below the age of 60.
- The applicant should be in stable employment with a consistent salary. They must prove 2 years of employment with a company or 5 years of employment if self-employed, the latter being the case for your startup.
- A current financial statement of at least 6-12 months should be produced to the lender.
- You must meet the credit score required to be eligible for an unsecured loan. This is essential and there is no way to get around it.
- Any pending debt in the form of EMI or loans is also taken into consideration.
- As in secured loans, here too, documents corroborating all the above information must be produced along with your loan application.
Repayment for Secured and Unsecured Loans
The repayment terms for both secured and unsecured loans vary. These differences are not just because of the nature of the particular loan but also because of rules made by lenders that are applicable to their institution.
In the case of secured loans, repayment terms are considered to be very flexible. You can make settlement payments or one large lump sum payment to clear your loan without any fear of fines or charges. You also have the option to pay your loans faster with a more hefty EMI within a short time or choose smaller amounts over a longer period. This flexibility is due to the reduced risk that the lender faces thanks to the collateral. This collateral also helps reduce the interest rate while increasing the overall tenure of payment.
When it comes to unsecured loans, on the other hand, the borrower is at an advantage since the lenders have little to no control over any of their assets. However, this puts the lenders at increased risk which makes them increase the interest rates and reduce the loan tenure. At most, lenders will give you 7 years to pay off the loan.
Where to Get Secured and Unsecured Loans
Now that you have understood the key features of secured loans and unsecured loans, let’s look at some of the places where you can apply for them.
Some platforms for secured loans
- TD Bank
- PNC Bank
- People’s United Bank
- Coastal Credit Union
- America First Credit Bank
- Citi Bank
Some platforms for unsecured loans
- TD Bank
- Bank of America
- Blue Vine
Learn more with us
- Bank loan guide for startups
- Debt funding guide for startups
- What are pro-forma financial statements?
- Should I hire a startup fundraising consultant?
- Learn more about accounting for startups
Access more guides in our Knowledge Base for Startups
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