As businesses and SMEs in South Africa navigate the complex landscape of financing options, there is often confusion surrounding the terms secured and unsecured lending.
To shed light on this topic and empower entrepreneurs with knowledge, Geddes Capital provides a comprehensive guide to understanding the key differences between these two types of lending.
Secured lending involves borrowing money that is backed by collateral, such as property or other assets including vehicles, listed shares, art or gold coins or plant and machinery, which can be seized by the lender in the event of default.
Conversely, unsecured lending does not require collateral and is based solely on the borrower’s creditworthiness. While this can be advantageous for SMEs and startups without significant assets, it typically comes with higher interest rates and shorter repayment terms to mitigate the lender’s risk.
Unpacking which situations a lender might prefer secured lending over unsecured lending, Founder and CEO of Geddes, Brent Geddes says, “Unsecured is quicker to access and potentially has less red tape to put in place, but will be more expensive and have a bigger impact on cash flows of the business to pay back the loan”.
He goes on to say, “Unsecured loans tend to have to be paid back in months. The impression that they provide long term cash flow for the business can be questioned. A secured loan will take a bit longer to put in place but can be structured to more suitably match the cash flows of the business.”
How does the risk assessment differ?
Unsecured loans mainly look at the immediate cash flows of a business for the lender to make a decision, as they need the loans repaid quickly to reduce their risk as fast as possible.
“Borrowers are ultimately liable to repay the money, but in the case of unsecured loans, the lender only has recourse to get the money back from the borrower. If the borrower has offered a form of security, the lender then has the recourse in the event of default, to use the value of the assets to get repaid. This can be a lengthy process, and the last road a lender wants to go down”, says Geddes.
Secured and unsecured loans differ in terms of repayment flexibility and the amount borrowers can access. Unsecured loans will be relatively fixed in terms of repayment structure, and usually have to be repaid quickly. Typically, in less than 12 months, and in some instances, in as short as 6 months.
Secured loans, however, allow the lender to be much more flexible when looking at repayment terms. The loans can be structured over a much longer time frame and priced at lower interest rates.
In the event of defaulting, there are substantial consequences that need to be considered.
“In both instances the borrower is liable to repay the loan and any penalties and legal costs incurred. In the event of unsecured, the lender only has recourse to the borrower directly and the directors and guarantors in their personal capacity. This can result in default judgments being marked on the borrowers credit ratings, which will affect their ability to borrow money in the future.”
When it comes to mitigating risk with both types of loans, Brent believes there are certain steps to be followed.
“Not only must the lender look at the cash flows of the business and its ability to repay the loan, but also the quality of the management team, management’s personal balance sheets, as well as doing quite a lot of work on the security itself. The lender needs to establish who owns the security, what it is worth, if it’s insured and how easily it can be liquidated in the event of default.”
While it may be a little less complicated when it comes to unsecured loans, it does mean looking at the cash flows of the business and how easily one can access those cash flows in the event of default.
It’s essential for businesses to carefully consider their financing needs and risk tolerance when choosing between secured and unsecured lending options. Understanding the advantages and limitations of each can help entrepreneurs make informed decisions that align with their financial goals and objectives.
