Unsecured Business Loans: How Do They Work?

Unsecured loans allow you to borrow money without risking assets. Are they worth the hefty price? Read on to learn more about unsecured loans.

I worked for a few years in a customer-facing role selling business loans. I dealt with a common refrain among older business owners, “Why can’t you just do this based on my signature?”

For decades, banks did signature loans for borrowers who had a long relationship with them. The loans would be done in a day and the borrower would have the cash-based only on their guarantee.

Modern banks make finding a small business loan much harder. Hundreds of bank failures and thousands of new regulations have made it much harder for banks to loan money in high-risk situations. That said, you may still be able to get an unsecured business loan. Here’s how.

Overview: What are unsecured business loans?

Unsecured business funding is when a business can get a loan without pledging any collateral. The majority of business loans are granted with a direct use in mind (such as real estate or equipment) and the loan is collateralized by that use. This means you can’t sell the equipment or real estate without paying off the loan first and if you default on the loan, the bank will repossess the collateral and sell it to reduce the loan balance.

No-collateral business loans are generally for working capital and rarely would be large enough to purchase real estate or a substantial amount of equipment.

How do unsecured business loans work?

If you manage to get an unsecured business loan from a bank (not easy) you’ll likely have to personally guarantee the loan. That means if your business defaults on the loan, there won’t be any collateral to repossess and the bank will come after you to pay the balance. If you get the loan from an online lender or credit card company, you may not have to personally guarantee.

Unsecured loans will almost always have higher fees and interest rates; even government-guaranteed microloans can have interest rates up to the mid-teens.

4 types of unsecured business loans

Here are four common types of unsecured small business loans.

1. SBA

SBA loans under $150,000 are not required to be collateralized. Between $150,000 and $350,000, the bank is required to “seek additional collateral,” but if that exists the deal can still be done unsecured.

In both of these instances, the bank takes a general UCC filing on the business. UCC stands for Uniform Commercial Code, and it is how states register collateral for items like accounts receivable and equipment. You can think about it like the title on a vehicle or real estate.

The general UCC means the bank will come after any assets you have that do not have prior liens. These are usually things like desks, computers, and inventory. That means the loan is not technically unsecured but is sort of in business loan purgatory. You are free to do what you want with your assets and sell them if necessary, but the bank will come for them if you default.

The most common SBA loans are working capital loans and business loans for startups.

2. Lines of credit

If you have a great relationship with your bank, you may be able to pull off an unsecured line of credit. Most banks do everything they can to avoid unsecured lines of credit above $50,000. Even then, it’s likely you will have to sign over the same general UCC as you do with SBA loans.

I was once months into a deal to do an SBA export line of credit for a business that purchased cornmeal in the Midwestern U.S. and shipped it to Indonesia to be used as animal feed. The process was incredibly complicated, and the SBA required the bank to be in the first position in our UCC filing.

Turns out, during underwriting the borrower had gotten what he thought was an unsecured $25,000 line of credit from a big bank to make ends meet until we had SBA approval. The big bank secured its loan with a UCC filing and it was now in the first place. The borrower made an $80,000 cornmeal purchase and needed to be reimbursed to make his own mortgage payment but he was technically in default on the export loan.

We had to get an emergency conventional loan approved until he was able to get the “unsecured” line of credit closed and the UCC removed. Unsurprisingly the big bank took its time. Make sure you read the loan docs that you sign and know what they mean.

3. Credit cards

Credit cards are the most common form of unsecured business financing. One bank I worked for automatically approved 10% of every loan amount in potential credit cards to try to sell them to clients.

Credit cards are also the most expensive of these options. They have sky-high interest rates and often have an annual fee to boot. If you use them, stick to general operating expenses and pay the balance off monthly.

4. Merchant cash advance

The reason banks push credit cards on clients is because of the high interest rates and the juicy merchant fees. Every time you use a credit card the business owner has to pay a merchant fee to process the transaction. Merchant services can be done through your bank or a third party.

Some merchant service providers will allow you to do a merchant cash advance. This is like a payday loan for a small business. The merchant services company knows how much you do in credit card transactions and underwrites the transaction based on those inflows.

After you get the advance, the balance is slowly paid down as you accept credit card purchases. As you likely expected, merchant cash advances have fairly high fees. Use them only as a last resort.

Should you use an unsecured business loan to finance your business?

Here are a few pros and cons of unsecured business loans.

3 benefits of unsecured business loans

Unsecured business loans can provide some appealing benefits.

1. Frees up collateral

The key benefit to unsecured business financing is that you have the freedom to use your assets as you see fit. If you need to sell equipment to pivot to a new business line, you can. If you need to factor in your accounts receivables to speed up your cash conversion cycle, you can. If you have a big month and sell out of your inventory, you don’t have to worry about it.

2. Speeds up the approval process

A big chunk of underwriting time for real estate and equipment loans is appraising the collateral. A big chunk of time each month for keeping revolving lines of credit open is reporting the borrowing base to the bank. With unsecured loans, you skip this step.

Additionally, many modern lenders use an algorithm to score and approve unsecured loans because they are smaller than a typical real estate or equipment loan. This makes the process a lot easier and faster.

3. Reduces risk

Being able to sell your collateral when you want isn’t the only benefit to not securing a loan with it. You’ll also be able to use the collateral to keep operating the business if you default on the loan. This will give you the chance to turn around and eventually pay the lender back.

3 disadvantages of unsecured business loans

However, unsecured business loans also have their downfalls.

1. Interest rates

There is a clear relationship in finance between risk and interest rate. Lenders that can’t come after collateral need to be compensated for that risk. If you get an unsecured line of credit or credit card, make sure you keep the balance at $0 as much as possible.

2. Fees

Lenders know that high interest rates are unattractive and will try to cut the rates and make up for it with fees for things like closing costs, line utilization, line non-utilization, document preparation, business plan creation, or executive bonuses.

Keep an eye on your loan docs and make sure you go over all loan uses. Sometimes the lender will pay their fees with the loan so that you don’t start with a $0 balance but you also don’t have to come up with cash for the fees.

3. Discipline

I worked with a crotchety old man (which he would have proudly called himself) who was seasoned by decades of working with high-risk businesses. He was in the SBA department and would often want collateral on loans that technically didn’t require it to impose discipline on the borrower.

If a borrower has to pledge a second lien on their residence to get a loan or report a borrowing base every month to keep access to a revolving line of credit, they’re far more likely to pay the loan on time.

That discipline is a good thing to have when you’re running a business. The threat of losing critical assets or the need to support a borrowing base help to make sure you don’t live beyond your means. Having an unsecured loan does not impose any discipline on your business because there isn’t a direct risk to your assets if you default.

Should you secure an unsecured loan?

Unsecured loans seem ideal on the face. You get the cash without the risk of losing anything. In reality, most successful small businesses don’t use unsecured loans much because of the expense. Unsecured loans are one step above loans from small business investment companies (SBICs) or mezzanine funds and are often the last gasp of a failing business.