By Frances Coppola
Unsecured business lending can be broadly grouped into two categories:
Fixed-term unsecured business loans can be useful, especially for smaller business purchases. They enable small businesses to spread out essential business expenditures over months or years. But if your business needs flexibility, you could consider a credit facility instead.
Here is a run-down of the commonest types of unsecured business lending and credit facilities.
Unsecured business lending usually has a fixed time limit, though a loan's maturity date can vary, typically from five to 10 years. On the maturity date, the amount advanced, or "principal," must be repaid. Unlike a credit facility, the entire principal is usually transferred immediately to the business's bank account or disbursed in the form of a check.
During the lifetime of an unsecured business loan the business pays interest, usually monthly. When the loan expires, the principal must be repaid in full along with any outstanding interest. This is known as a "bullet repayment."2 Loans where the principal is repaid at maturity are known as "balloon loans."3
Some unsecured business lending facilities have repayment schedules in which the business pays back the principal gradually rather than in one bullet repayment at the maturity date. This reduces the risk that the business will need to refinance the loan at a much higher interest rate on maturity, but paying the principal each month means the firm's monthly payments are considerably higher than on a balloon loan.
Unsecured business lending often includes arrangement fees, typically a small percentage of the loan principal. These may be paid up front or added to the loan itself. Additionally, there can be penalties for early repayment of the loan.
It's also possible to get very short-term unsecured loans, with maturity of, say, three to 18 months. Since these loans can often be obtained with little or no notice, they can be useful for unexpected business expenses. However, the interest rates on these loans can be high, and the amounts advanced are typically smaller than with longer-term unsecured business lending.
Interest rates on business loans can be fixed or floating, and interest may be calculated daily or monthly.
Fixed interest rates are determined by the lender based upon the risk of the loan, which is calculated using a process of credit scoring. Business credit scoring can consider the company's annual sales and credit history, its business outlook, the quality of its management, and the purpose of the loan. The personal credit scores of owners and managers may also be taken into account. For a short-term loan, a fixed interest rate may be set for the entire term. But if a loan is longer-term, the loan terms and conditions may allow the lender to reset the interest rate at pre-determined periods.
Floating interest rates are usually set by reference to a benchmark rate, such as the London Interbank Offered Rate (LIBOR). A typical floating-rate business loan will have a margin of a few percentage points over the benchmark rate. As with a fixed interest rate, the margin is set according to the lender's view of the risk of the loan. Thus, a low-risk business loan might be, say, LIBOR + 5 percent, while for a high-risk loan the margin could be in double digits. Depending on the loan terms and conditions, the margin may be fixed for the lifetime of the loan, but the benchmark rate will vary with market conditions.
Floating rate loans expose the business to market risk, since the interest rate on the loan varies with market conditions. Larger businesses sometimes hedge against this risk with interest rate swaps and other financial derivatives. For unsecured business lending that is fairly short term and low in value – which is more typical for small business borrowers – businesses and their lenders typically prefer fixed interest rates.
For both fixed and floating rate unsecured business loans, if the principal is repaid gradually over the lifetime of the loan then the interest payment gradually reduces along with the principal. Thus, the amount the business must pay each month slowly falls during the lifetime of the loan.4 However, some fixed rate loans with principal and interest repayment schedules spread the interest payments evenly over the lifetime of the loan, so that the amount paid per month is always the same.5 Businesses may wish to consider whether they prefer the certainty of a fixed payment per month or the prospect of easier cash flow conditions in future as monthly payments reduce.
A "line of credit" at a bank is possibly the commonest form of unsecured business lending. The familiar business overdraft is a line of credit. It allows a business to borrow flexibly up to an agreed limit. So, for example, a business that has an overdraft of $50,000 can borrow up to that amount, either in one transaction or – more usually – through a series of transactions over an extended period of time. Most of the time, the business will probably borrow much less than that – indeed, at times it may not borrow under the facility at all. Typically, interest is charged only on the drawn balance, so as the drawn balance varies with cash flow, so too do the interest payments. Overdraft interest rates are usually fixed, though the rate can be changed by the lender periodically. Other lines of credit, such as revolving credit facilities, may have floating interest rates similar to those on unsecured floating rate business loans.
For businesses with uncertain cash flow, lines of credit can be essential lifelines, enabling them to meet their obligations to suppliers even when customer invoices are yet to be paid. However, overdraft interest rates can be high, and overdrafts typically have arrangement fees and management fees. Depending on the terms and conditions, overdraft limits can also be changed without notice or even withdrawn. Businesses may wish to have in place alternative means of financing to reduce reliance on bank lines of credit.
Another type of unsecured credit facility is a corporate credit card. Corporate credit cards are like overdrafts, in that they allow the business to borrow flexibly up to a limit, and interest is charged only on the drawn balance. Unlike overdrafts, corporate credit cards may have an interest-free period: if the business pays off the drawn balance in full within that period, there is no interest charge. Credit card interest rates are usually fixed, but the provider typically has the right to reset them from time to time.
Corporate credit cards can be a useful form of unsecured short-term business lending. However, they may not be accepted by all suppliers. Many cards have a cash advance facility, which can enable companies to pay suppliers by wire transfer, but cash advances typically incur additional fees over and above the interest charge.
Like overdrafts, corporate cards may have arrangement fees, and they may also have management fees, chargeable monthly or yearly. However, there is an enormous range of corporate credit cards, and card providers also provide rewards and incentives that can offset fees and interest for some businesses. Businesses may find it worthwhile to shop around.
The U.S. Federal Government's Small Business Administration (SBA) program helps qualifying businesses to obtain affordable "unsecured" business loans and credit facilities. The SBA does not itself provide loans to businesses. Rather, it provides a federal government guarantee for otherwise unsecured business loans and credit facilities provided by traditional lenders, and it also gives businesses access to other providers such as community lending and microfinance programs. As a result, qualifying businesses can benefit from lower interest rates, larger loans, higher credit limits, and longer loan maturities than would otherwise be the case. To qualify, a business must be registered in the U.S., the owners must have equity in the business, and the business must be unable to obtain affordable finance without SBA assistance.6
In recent years, there has been enormous growth in "alternative lending." While that term refers to a broad range of new online business lending options, it often takes the form of a digital platform that directly connects business borrowers to providers of finance – what is known as "peer-to-peer lending." Unsecured business lending obtained from peer-to-peer platforms can be at lower or higher rates than those provided by banks, depending on a variety of circumstances. Peer-to-peer platforms may provide finance to businesses that traditional lenders consider too risky.7
However, alternative unsecured business lending is not unconditional and can be complex. Alternative lenders perform their own credit assessments, and may have idiosyncratic preferences about the sort of business ventures they are prepared to fund. There are a great many alternative lenders, some of which offer riskier forms of financing such as equity partnerships and mezzanine debt.8 Businesses considering alternative finance may wish to spend some time evaluating the various alternatives available.
The smorgasbord of unsecured business lending, from straightforward loans and credit facilities to alternative finance products, can appear daunting. But it creates opportunities for business managers to put together flexible and affordable financing packages to help them manage their cash flow and develop their business. Business managers may find it worthwhile to spend time researching and evaluating this diverse marketplace.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. 2016 Small Business Credit Survey, U.S. Federal Reserve; https://www.newyorkfed.org/smallbusiness/small-business-credit-survey-employer-firms-2016
2. “Bullet repayment,” Investopedia; https://www.investopedia.com/terms/b/bulletrepayment.asp
3. “Balloon loan,” Investopedia; https://www.investopedia.com/terms/b/balloonloan.asp
4. “Types of Loan Repayment Schedule,” Iowa State University; https://www.extension.iastate.edu/AGDM/wholefarm/html/c5-93.html
6. “Small Business Administration,” U.S. Small Business Administration; https://www.sba.gov/
7. “Alternative Lending,” Ernst & Young; http://www.ey.com/Publication/vwLUAssets/ey-understanding-alternative-lending/$File/ey-understanding-alternative-lending.pdf