Is Securing an Unsecured Business Loan Right for Your Business or Franchise?
Consider these drawbacks before getting an unsecured business loan for your venture
Entrepreneurs seek business loans to fund their startups, or for investing in a franchise. The cash infusion is inevitable, as it is required for continued business operations, to pay off salaries or rent, purchase inventory, or to take up other day-to-day business functions. In order to meet the needs, companies at times seek loans in lieu of collateral. The loans, in this case, are secured against a personal asset that can be redeemed in case a person defaults on a loan.
That said, there are times when an entrepreneur needs urgent capital funding, but doesn't have anything for a mortgage. This is when unsecured business loans play a key role. However, given the characteristics of these loans, it entails a high-risk proposition for lenders, as there is a chance of the borrower defaulting on repayment.
Besides, there are other drawbacks that need to be taken into consideration, both for the lending point of view, as well as from the borrowers before thinking of relying on unsecured loans.
Higher risk means higher interest rates .
Banks and financial institutions often provide a loan without registering any asset as collateral. However, the absence of collateral does not mean that the bank won’t safeguard its interest. As these loans mean higher risk for the lender, they carry a very high rate of interest. The lenders always try to tread the path where they can surely recoup their losses, because of which the rate of interest over the repayment is higher.
As an unsecured business loan does not involve mortgaging of an asset, the approval process is generally not an easy one. The creditworthiness of an individual based on historical repayment data is duly assessed, and in case the credit rating is anywhere lower than 500-600 (based on few institutions) getting approval for the same is highly unlikely. On the other hand, with a secure loan for franchise or startup, creditworthiness, though necessary, is not a key deciding factor, as the value of assets is assessed to determine if it will fetch the required investment.
While your business might still be in its initial stages, or might need financial support for a long period of time before it reaches equilibrium, funds through unsecured business loans are facilitated only for a short period of time. The key reason behind this is that banks would not want to block money in a risky proposition for a very long period. A small period increases the chance of the borrower to easily pay back the borrowed money.
In the Case of Default
At any point in time, during the loan disbursal period, if there is an instance of default it may lead to varied repercussions, depending on the terms and conditions agreed to while signing the loan agreement.
Drop-in credit score: One of the biggest repercussions is a significant drop in credit score that will hamper your capability to tie up funds for any future needs. This will be effective, even if one installment has been missed.
Hike in interest: While a businessman is already paying a higher interest rate, in case of a missed payment, the interest rate will rise further. This has been designed to recover all dues pending on the borrower.
Accumulation of amount: The amount to be paid i.e. the principal amount in addition to interest rate gets accumulated, as it is compounded annually, the sum will be more than what was actually due to be paid. To add to this, penalties are also levied, which are decided prior to signing the agreement, and are part of the terms and conditions set.
Legal proceedings and foreclosures: Bankers at times resort to legal proceedings and arbitrage to recover all the money that is pending. Failing to repay repeatedly will mostly turn the events to legal counsel. In case there is lack of mutual consent and inability on the part of borrower to make a repayment, the foreclosure process begins in which the lender will have complete authority on any of your assets to recover payments.
Difficulty in getting future loans: Another key consequence is the inability to secure additional funding for any financial needs going forward. Due to the decline in credit score and the impact of a legal proceeding will create a bad credit history.
Businesses that are relatively new, and can demonstrate their repayment capabilities can get quick funding through unsecured loans. Also, businesses having bad credit can also look for this option, as it has a mortgage tied up for ensuring security. It can be a great source of financing in case you need a small cash infusion. On the other hand, for meeting bigger investment requirements, other available options such as secured loans, a combination of debt and equity can also be considered. After having considered the business requirements, the decision with respect to the type of loan must be made. Lastly, once the loan has been disbursed, debt management to eliminate chances of default is the required step thereafter.