How Does an Unsecured Line of Credit Work?

Business lines of credit can be an important tool for small businesses that need access to working capital to stabilize their cash flow. Even the most successful small businesses may find themselves in need of supplemental capital and flexible funding during crucial periods of growth. 

In the case of an unsecured line of credit, the business can even access financing without having to risk any collateral. Having a reserve amount of cash to draw upon acts as an insurance plan for a small business, and, when used responsibly, can be a crucial component to a company’s financing strategy. 

What Is a Line of Credit?

A business line of credit is an option worth considering for small businesses that need access to capital but might not be the right fit for a traditional loan. With a loan, small businesses receive a lump sum, often after a tedious process of proving creditworthiness and, in many cases, putting up significant collateral. 

An unsecured line of credit, however, acts as a backup plan for new and established businesses. It is one of the only types of funding in which a business can gain access to capital without having to pledge major assets. Once approved, a business can access the cash, if it needs it, as a periodic supplement to standard cash flow or to cover unexpected expenses. 

Should a business decide to draw from the line of capital, it only pays interest on the amount of cash received. This allows small businesses to access cash incrementally, without the burden of an interest payment on a large lump sum. 

Secured vs. Unsecured Lines of Credit

Access to Cash at Variable Interest Rates

Both secured and unsecured lines of credit offer the important benefit of cash on demand. Small businesses often find themselves in need of bridge financing to get through lean seasons, or in need of a cash infusion during a period of growth. For these purposes, having a line of credit can offer peace of mind. 

With lines of credit, businesses can draw the exact amount they need, and either repay that amount once cash flow stabilizes, or pay interest only on the capital that was spent. 

Collateral vs. Personal Guarantee

The most significant difference between secured and unsecured lines of credit is the collateral required to gain approval from a bank or alternative lender. 

Secured lines of credit require businesses to guarantee the cash extension using significant collateral, such as major equipment, business inventory, or even an owner’s personal home. 

Unsecured lines of credit are less risky for business owners because they do not require any collateral to be approved, but most lenders will still require a personal guarantee from everyone who owns at least 25% of the business.

Assets and Personal Credit

In the event that the extended capital cannot be repaid, a secured line of credit means that a lender can seize the borrower’s assets put up as collateral. This can be risky for business owners who may have pledged their business or personal property. 

With an unsecured line of credit, the lender cannot call upon any collateral, making such loans significantly riskier for them, but they can still pursue debt collection, which can have an extremely negative impact on the personal credit scores of the business owners and the business’s credit.

Established Business History

Though terms and rates are different for each bank line of credit, a lender will almost always want to see at least two years of business tax returns, as well as solid business and personal credit in order to extend either a secured or unsecured line. Because the funds are expected to be repaid via the business’s revenue, the lenders generally will also want to see established annual revenue. 

In the case of a secured line of credit, those annual revenue requirements may be lower, because the cash outlay is less risky for the lender than in the case of an unsecured line. Similarly, interest rates for secured lines of credit will generally be lower, as the lender has the ability to recoup funds via collateral, if necessary.  

Pros and Cons of Unsecured Lines of Credit

Pros Explained

One of the key benefits of an unsecured line of credit is that small business owners can access capital without pledging major assets, such as property or inventory. This allows businesses to quickly cover cash-flow needs and invest in growth opportunities without the fear of a lien on their business or personal property. 

Additionally, unlike with a traditional loan, once the funds are repaid the borrower can access the full amount again. If businesses are able to manage their revenue and expenses correctly, this rotating reserve of cash can be a very useful tool. 

Cons Explained

Because an unsecured line of credit is riskier for lenders, they often charge higher interest rates and can set less-favorable terms. While the terms of each deal may vary, with an unsecured line of credit, business owners must personally guarantee the financing, which means lenders can come after the business owners if the funds are not repaid. 

The higher risk for lenders also generally means lower borrowing limits, yearly fees, and stringent approval requirements. Most importantly, if businesses do not manage a line of credit correctly, the compounding interest can become a major financial burden.

How To Get a Line of Credit

Understand Your Credit

As a first step to searching for any kind of financing, it is important to have a solid understanding of both your personal and business credit history. Because an unsecured line of credit does not require collateral, lenders will rely heavily on their analysis of an owner’s creditworthiness, as well as a business’s ability to repay the funds. By understanding both your own and your business’s credit scores you can rule out the possibility that lenders may require higher qualifications for issuing credit. 

Decide on a Type of Lender

Unsecured lines of credit are available from traditional banks, as well as alternative and online lenders. Online lenders often have more-flexible thresholds for approval, which can be helpful for business owners with lower personal credit scores or for a relatively new business without an established history of revenue. Those easier qualifications usually come with higher rates and lower borrowing limits, so it’s important to evaluate different lenders to find the relationship that best fits your business needs. 

Identify a Loan Product and Apply

Once you have chosen a lender, you can evaluate what type of product works best for your company. If you decide to go with a secured line of credit, you will need to put up significant collateral in order to apply. With an unsecured line, you will need to be comfortable signing a personal guarantee for any funds used. 

The application process varies by lender and product, but generally, applying for a line of credit, especially for an unsecured line, can be much faster and less rigorous than applying for a traditional loan. 

Alternatives to a Line of Credit

It is important for small businesses looking to access capital to evaluate all options before signing over personal guarantees or collateral. In many cases, small businesses can find success and growth by engaging a combination of financing options, as long as they have a solid repayment plan. Some alternatives to lines of credit include:

Loans 

Short- and longer-term loans are tried-and-true options for small business financing. Whether through a large financial institution or the U.S. Small Business Administration (SBA), loans can be useful for growth, acquisition, and startup. More-established businesses are often granted higher loan amounts with more favorable terms, but startups can benefit from microloans as well. 

Equity

A common way for startups and small businesses entering key growth phases to gain capital is to sell equity. This kind of investment can come from various sources, including friends and family, angel investors, or venture capitalists. It’s worth considering equity investment as part of a small business financing strategy, but only if you’re willing to entertain investor input in your operations. 

Crowdfunding

Startups and small businesses at any stage can engage in online crowdfunding as a way to access cash. While crowdfunding requires a lot of upfront input in terms of marketing, networking, and word of mouth, this financing is very low-risk and comes with zero interest. In addition, the U.S. Securities and Exchange Commission (SEC) now permits equity crowdfunding, which allows companies to sell securities via a registered broker.

Credit Cards

Business credit cards are the most common form of financing for small businesses and the easiest to obtain. Credit cards are a helpful way to supplement cash flow, as long as a business can pay the balances on time. Credit cards often have high interest rates and lower credit limits than lines of credit or loans, so they should be used responsibly.

The Bottom Line

A line of credit can be a valuable tool for small businesses looking for bridge financing or a reserve to address cash-flow problems. Unsecured lines of credit may be a good place to start for newer businesses looking to avoid risking major business or personal assets, though the company’s revenue must support the repayment terms to sidestep high interest penalties. 

Frequently Asked Questions (FAQs)