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Unsecured vs. Secured Loans
First things first: what does security mean when it comes to loans?
Security refers to whether or not the borrower has put up collateral or a personal guarantee in exchange for a loan. Collateral is a significant asset or assets that can be repossessed and sold off by a lender if a borrower fails to repay the loan in question. There are many assets that can be used as collateral. In general, lenders want collateral to be valuable, stable, and easily liquidated in the case of default.
In the case of a personal guarantee, if the business defaults, the guarantor is responsible for paying-off the loan.
Most of the time, real estate is the go-to collateral asset. However, inventory, equipment, and accounts receivable are also common inventory assets. From the lender’s perspective, these assets are all stably-priced, valuable, and easy to sell. For example, many traditional lenders offer a loan product known as equipment financing, where the loan is underwritten specifically to be used on a piece of equipment. If the borrower can’t pay back the loan, the lender repossesses the new equipment and sells it to recoup its loss. Equipment financing is a textbook form of a secured business loan.
In short: secured loans require valuable assets for collateral. Unsecured loans do not.
What is a Credit Score?
Three companies – Experian, Equifax, and Dun & Bradstreet maintain a credit profile on individuals and companies. While slightly different, credit scores are somewhat standardized to show a lender what type of default risk they may incur when lending money.
Your company’s credit score is a number that shows any potential investors or lenders how likely your business is to go under, pay off its loans, or otherwise succeed.
There are a number of factors that go into a business’s credit score, and many of them reflect similar metrics used to calculate your personal credit score. These metrics include, but are not limited to:
Debt payment history: Potential lenders want to see that you’ve made full and on-time payments on existing debts. Late payments or missed payments can damage your business credit score.
Credit Age: How long has your company had credit? The longer you can show your business’s history of dealing with (and paying off) business financing, the higher your credit score.
Total debt and debt usage: How much debt does your company currently carry? If you’ve got a business line of credit or a credit card, what percentage of that line of credit’s limit have you drawn on?
Industry risk: Some industries are inherently riskier for lenders simply due to industry statistics. Restaurants, alcohol sellers, and cannabis companies are prime examples. Simply operating in these industries can hurt your credit scores.
Company size. For lenders, the more employees you’ve got, the more stable your business is as a borrower. A big staff can be helpful on your credit report.
If your company’s got a low credit score, lenders will take that to mean that your company is less likely than others to repay your loans. If you’ve missed payments on a debt in the past, lenders see your company as a risk. If you’re operating a relatively new business, lenders don’t see the sort of long history of success that might indicate a sure thing.
In short: credit scores are a simple way for lenders to put a firm number to how likely your company is to pay back its loans. Lower scores = less likely to repay.
How Do Lenders Protect Themselves?
When offering a business loan to any prospective borrower, lenders use several techniques to protect themselves from the chance of losing too much money. Approving any business loan application is a risk, but by using these techniques lenders are able to minimize risk.
Small Loans. The first technique is simple: if you want to minimize how much money you can possibly lose, you simply loan out the smallest possible amount of money. If you lend a business a large loan amount without security and they default, you lose a significant amount of money. If your credit is less than stellar and you’re unable or unwilling to put up collateral, you should expect a fairly small loan amount.
Personal Guarantees. Another way lenders can reduce risk is by insisting that a borrower make a personal guarantee on a loan. A personal guarantee is a binding promise made by the borrower that even if the business isn’t able to repay the loan as an entity, the individual will. These guarantees can be for the entirety of the loan balance, or for a smaller percentage. Regardless, default on a loan with a personal guarantee opens up significant personal liability.
High Interest Rates. Like with any bet, if you’re going to open yourself up to lose a bunch of money, it needs to be worth your while. No one’s going to place a $100 bet to win a nickel – that’s too much downside for limited upside. So when you’re doling out an unsecured loan to a company with bad credit, you charge high interest. If you’re going to risk the money, you’ll want it to be worth your while.
In short: loan approval often requires collateral and other techniques to protect lenders from losing money. If you’re unable to offer collateral, they may require that your personal assets or credit are on the line, and they’re unlikely to offer you as much money as you’d like.
Types of Bad Credit Business Financing
So if you’re going to seek out funding with poor credit, what form does that funding take? Fortunately for borrowers and business lenders alike, several different types of funding are available. Depending on your company’s specific needs, one or more of the following types of loans could be a great fit.
Term loans are the most basic type of loan you can think of. The prospective borrower fills out a loan application. A lender underwrites a loan to a business, which pays back the loan amount in addition to an agreed-upon interest rate. These term loans are often sorted by their repayment terms: short-term or long-term. Short-term loans are more common for unsecured loans to businesses with bad credit since the lender’s money is in the borrower’s possession for a minimal amount of time. These loan offers will often come with a repayment term under eighteen months and high interest.
Revolving Lines of Credit
Revolving lines of credit encompass two main forms of business funding: lines of credit, and credit cards. Both of these types of funding are able to be paid off and borrowed again, meaning that proper management of a revolving line of credit can result in long-term access to business financing whenever you need it. While large lines of credit depend on strong creditworthiness and, often, significant collateral, many smaller versions exist for companies with credit issues.
Business Lines of Credit
If you’ve got a low business credit score and often find your company in need of additional cash flow, you may want to look into a business line of credit. For many types of businesses, a line of credit can be a lifesaver when the going gets tough.
In a more traditional loan, the borrower receives the funds up front and pays them back as time goes forward. In a line of credit, however, payments don’t begin until the borrower draws on the line of credit.
For that reason, many businesses keep a business line of credit available to them even if they’re not drawing on it constantly. That way, if an emergency springs up and the business needs money quickly, there’s no need to seek out a different loan option: the money’s already there.
Lines of credit are flexible, and can be used for nearly every use: paying employees, buying equipment, and utility bills. If you’ve got bad credit and aren’t able or willing to offer assets for collateral, your interest rate might be higher than you’d like. But one of the biggest upsides to a business line of credit is that you only pay interest on the money you spend under your credit limit, which mitigates some of the issues created by high interest.
Business Credit Cards
Business credit cards work much like personal credit cards. The card issuer assigns each card holder a limit, and the card can be used to make purchases up to that limit. Like in a business line of credit, borrowers are able to pay off the credit card and then borrow again up to their credit limit.
So what’s the difference between business credit cards and lines of credit? For one, Business lines of credit tend to be larger and have lower interest rates than business credit cards. They’re also able to be spent on a wider variety of expenses, as money from a line of credit can be transferred directly into the borrower’s bank account.
That’s not to say business credit cards don’t have their advantages. While they tend to be smaller and carry higher interest, you can usually get a business credit card faster than you can take out a line of credit, and credit score requirements are likely lower. On top of that, business credit cards earn points and rewards just like personal credit cards, so if you’ve got small purchases to be made day after day, making that purchase with a business credit card can lead to rewards along with building up your credit.
MCAs, or merchant cash advances, are funding options that tend to be very available for small business owners with checkered credit histories, since your annual revenue matters much more than a credit score. MCAs are not loans, and are instead a purchase transaction.
In an MCA, the funding provider purchases a percentage of a company’s future credit and debit card sales. The application process is simple: advance providers look at your company’s revenue over the previous months and determine the size of your cash advance through that data. That advance is paid as a lump sum.
MCAs are paid back by providers taking a certain percentage of each and every card-based transaction, typically about 10%. They’re quick – often paid within a single business day – and are offered largely through online alternative lenders.
MCAs make money by using what’s called a factor rate instead of traditional interest. The factor rate is multiplied by the size of the advance, and this product is the total amount that the business must repay. Factor rates are typically between 1.0 and 2.0. If you receive an MCA of $12,000 at a factor rate of 1.13, you’ll need to repay 12,000 x 1.13, or 13,560.
MCAs have advantages and drawbacks. They’re fast, available for businesses with bad credit and no assets suitable as collateral, and they can be spent on any business need you can think of. However, the fixed repayment amount means that the effective APR of an MCA can reach the triple digits. You don’t want to have too many repeated MCAs in your business plan, as the repayment structure can create a crunch in your cash flow.
Much like a merchant cash advance, invoice factoring (also known as invoice financing) is a transaction-based form of financing and not a loan. Invoice factoring works quickly, and if your company deals with a heavy volume of invoices it can be a fast financing option when you absolutely need it.
In invoice factoring, a factoring provider buys your company’s outstanding accounts receivable at a slight discount. If your company has $24,000 in outstanding invoices, the factoring company may pay you $22,800, or 95% of the total. The factoring company would then take over the process of collecting invoices.
Because the lending is based solely on your outstanding invoices, factoring can be a great option for companies with poor credit and insufficient collateral. Invoice factoring moves quickly and requires no monthly payments (assuming your customers pay the factoring company on time and in full).
The biggest downside to invoice factoring is that it takes your customers’ experience out of your hands. Instead of having full control over the type of customer service they experience, they’re dealing with a third party. While most factoring companies are completely professional, this does create a layer of separation between your company and its customers.
How to Use Small Business Loans to Build Credit
Once you’ve decided which type of loan is best for your company, you should consider how best to use it to build good credit. While getting a loan with bad credit and no collateral is possible, the loan sizes are small and your low credit score will mean that the funding is expensive.
If possible, use these expensive loans to set your company up for better loans in the future. Keep an eye on the loans that include a minimum credit score above where yours currently stands. If you’re able to bring your bad credit score into the range necessary for larger, less expensive ones, your company will save money in the long run.
Refinance debt. Even if you’ve taken out loans with no collateral and poor credit, you may also find that it’s the right move to pay off the pre-existing debt that’s even more expensive. This is called refinancing, and it’s a key way to save money.
Expand. You can use your new loans to expand your business, whether that means opening a new location, developing a new product, starting a new marketing campaign, or a combination of the above. Expansion can also mean an increase in revenue – helping boost your credit.
Boost Working Capital. Working capital is defined as the difference between the cash you owe and the cash you’ve got on hand (or easily accessible) in a particular period. Having sufficient capital means that you’re able to do the things businesses need to do to survive: pay rent, fill payroll, and keep the lights on. Having sufficient working capital means having the ability to take advantage of the unexpected opportunities that pop up, which can lead to the income you need to boost that credit.
Equipment upgrades. You may need to upgrade your computers, your manufacturing equipment, or your vehicles in order to do the level of businesses you need to build up your credit. Using one of these loans can help finance these equipment upgrades, allowing you to boost your current operations and use that boost to increase your credit score.