It is evident from the name itself that an unsecured loan is a loan that doesn’t require a firm to put up any collateral of the firm as security. Unsecured business loans are good for businesses that are looking to borrow a smaller amount of capital, and that are unable, or unwilling, to secure the debt with the assets of their firms. Some examples of unsecured financing are personal and student loans, but we’ll focus on unsecured business loans in this post.
Keeping these in mind, we are going to explain the risk and disadvantages of unsecured business loans in our following sections.
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1. Higher Interest Rate
Unsecured business loans are often riskier. With an unsecured business loan, the lender has a clear path to recouping losses if the business fails to repay them because they can seize the collateral.
With an unsecured business loan, there’s no collateral, because of which the lenders will typically charge a higher interest rate on unsecured loans. If one is worried about paying higher interest rates, it may make sense for the business to get a secured business loan instead.
2. Decreasing Working Capital
When sales in business is on an increasing trend, it needs an increasing working capital to cater the huge demand and also to take care of extended credit to buyers.
Since Unsecured Business Loans keeps on decreasing being repayable in nature, the borrower always faces a shortfall of working capital when the business is increasing.
3. Huge Impact On Cash Flows
Unlike working capital credit facilities where there is no EMI repayment and only interest is supposed to be paid, Unsecured Business Loans have EMI repayment. These EMIs create a huge impact on cash flows as they are recurring and the amount is higher as it comprises both principal and interest components.
4. Privacy Concerns
Bank and credit union loans often come with strict privacy terms and conditions, but other options may be considerably less formal. However a majority of lenders should respect privacy laws similar to those required for banks, some may not.
5. Harder to Qualify For
Without collateral, lenders often look closely at certain aspects of the business, that include;
- business credit score
- Annual revenue
- Financial statements
- Business plans
- Cash flow projections
In the case of unsecured business loans, the lender’s goal is simple: minimise risk. Henceforth a business owner with a low business personal credit score will struggle to qualify for an unsecured business loan.
Therefore, qualifying for an unsecured loan is not likely if the business owners own a new business or have a poor credit score. They may need to apply for a different type of financing, like a credit card, or wait to apply for an unsecured loan once they are in better financial backing.
6. Loan Amounts Are Often Smaller
Due to the increased risk, generally online lenders are often less willing to approve large amounts of money, therefore, many unsecured loans come in small amounts.
The collateral protects the business lender, so they are more comfortable approving secured loans in larger amounts.
Unsecured financing can be a great resource if the business owners need to borrow money in the short term but will be unable to make significant investments. For instance, one probably will not be able to afford substantial investments such as:
- Expansion projects
- Purchasing equipment
- Placing sizable inventory orders
7. Leverages Balance-sheets
Since every NBFC or Bank has a maximum capping on unsecured lending, the borrower is forced to borrow loans from multiple organizations to fulfill its requirements.
Also the rate of interest charged in Unsecured Business Loans is too high as compared to any other loans and credit facilities due and the repayment tenure is short due to which the EMI’s are high.
This leverages the balance-sheet and over a period of time makes the borrower ineligible.
Final Words
In some cases, business owners use collateral to secure a loan. Such collaterals are bound to the term loan, so if the small business owner defaults on this secured loan, they must hand over the collateral to the lender.
Hence, the collateral secures the working capital lender if they aren’t repaid. But, unsecured business financing can also be an option. Unsecured business loans do not demand collateral, which is less risky for business owners.
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