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Unsecured Credit

See Also:
Debits and Credits
Credit Letter
Direct Tax
Credit Memorandum (memo)

Unsecured Credit Definition

Define unsecured credit as credit not collateralized by an asset. It is a common form of credit used for business. Furthermore, an unsecured credit line comes in many forms, including the following:

Though it may go unmentioned, many businesses use it to successfully finance any of their operations.

Unsecured Credit Meaning

Unsecured credit means credit which, when unpaid, cannot be reclaimed through the seizure of an asset. This is important to note because unsecured credit facilities may be confused with secured credit. Though lenders have other methods to regain the value of the credit they offered (such as a court decree saying the lendee must repay the lendor), there is no asset promised by the receiver of the credit.

On a small scale, unsecured credit loans are more simple to acquire than secured credit. For example, credit cards are the easiest method of credit to acquire outside of the financing of “friends, family, and fools”.

On a large scale, an unsecured credit agreement is fairly difficult to acquire. The example of this would be mezzanine debt financing: mezzanine financing is virtually as difficult to acquire as venture capital. In this situation, companies generally use an unsecured credit facility when they can not receive secured credit. This situation occurs when the company can not meet the requirements or obligations of the secured credit lender or prefer to keep their assets free of obligation.

The business owner makes the final decision on whether secured or unsecured credit is the best decision. A general rule of thumb would be that if the company has more to lose by collateralizing an asset then not receiving the financing, unsecured credit may be their best option. consult a trained CFO to find the best option for your business.

Unsecured Credit Example

For example, Karl is an entrepreneur who has started a company which manufactures precision electronics for the military. Because Karl makes each item to changing specifications, Karl must keep a lot of supplies on hand. He must have a strong base of credit to cope with his customer’s changing demands.

Karl has recently outgrown his current lines of credit. To make matters more complicated, he already promised almost all of his assets as collateral for other loans. With no option left, Karl must find an unsecured credit provider. He knows that credit cards will surely not be able to support his needs. He sees mezzanine debt financing as the only option.

After consulting with a trained CFO, Karl realizes that his company will actually lose profit by receiving the funding. The CFO clearly spelled this out in the financial analysis he provided. It seems the best option is for Karl to grow a little slower. Though he will have to deny some customers, it will ultimately result in a stronger business. Going forward, Karl’s company will be financed by free cash flow. Though Karl does not feel like as much of a “high roller”, he is happy that he made the prudent decision.

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Interest Rate Definition

See Also:
Effective Rate of Interest Calculation
Interest Expense
What are the 7 Cs of banking
Time Value of Money (TVM)
Interest Rate Risk
LIBOR vs Prime Rate
Federal Funds Rate Definition
Treasury Inflation Protected Securities

Interest Rate Definition

An interest rate signifies a borrowing cost. The interest rate definition is the rate the lender charges the borrower for the use of money. Quote interest rates as annual rates, which represent a percentage of the borrowed principal. Interest rates are used in all types of business and consumer loans, including auto loans, mortgages, credit cards, and any other contract that involves a borrower and a lender. A borrower with good credit – and therefore less risk of default – can borrow money at a lower rate than a borrower with poor credit.

Benchmark Interest Rates

Business and consumer loans, as well as interest rate derivatives (see below), often rely on benchmark interest rates, such as the fed funds rate, the prime rate, Libor, or U.S. Treasury rates. For example, a company may borrow money from a commercial bank at a rate equal to the prime rate plus a specified quoted margin. The quoted margin, or spread between the benchmark rate and the interest rate used in the loan, would depend on the credit standing of the borrower.

Interest Rate Derivatives

Furthermore, interest rates are also frequently used in financial derivatives, such as interest rate futures and interest rate swaps. With financial derivatives, the value of the derivative instrument depends on fluctuations in the underlying interest rate.

Calculate Interest on Loan

Use the following equations to calculate interest on a loan:

Simple Interest = Principal x Interest Rate x Time Periods

Compound Interest = Principal x (((1 + Interest Rate)^Time Periods) – 1)

Interest Payment = Principal x Interest Rate

Principal = Interest Payment / Interest Rate

If you want to overcome obstacles and prepare how your company is going to react to external factors, then download your free External Analysis whitepaper.

Interest rate definition

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Fixed Interest Rate vs Floating Interest Rate

See Also:
Effective Rate of Interest Calculation
What is Compound Interest
When is Interest Rate Not as Important in Selecting a Loan?
Nominal Interest Rate
Interest Rate Swaps

Fixed Interest Rate vs Floating Interest Rate

A loan can have a fixed interest rate or a floating interest rate. If the loan has a fixed interest rate, the interest rate remains constant for the duration of the loan. If the loan has a floating interest rate, also called a variable interest rate, then the interest rate fluctuates over the duration of the loan. Floating rates typically fluctuate with the overall market, with an underlying index, or with the prime rate.

Fixed interest rates and floating interest rates can apply to any type of debt or loan agreement. This includes monetary loans, credit card bills, mortgages, auto loans, and corporate bonds. Fixed rates and floating rates can also apply to financial derivative instruments.

Advantages and Disadvantages

Fixed Rate Loan

The primary advantage of a fixed interest rate loan is the elimination of uncertainty. Once the loan agreement is finalized, the value of the future interest payments is known.

A fixed interest rate can also be advantageous to the borrower (disadvantageous to the lender) if the market rates rise above the fixed rate, giving the borrower implicit gains (and the lender implicit losses). A fixed rate can be advantageous to the lender (disadvantageous to the borrower) if the market rates fall below the fixed rate, giving the lender implicit gains (and the borrower implicit losses).

Variable Rate Loan

The primary advantage of a floating interest rate is that it moves with the market rates. Of course, this can also be a disadvantage, depending on which way the market rates move and which side of the transaction the party is on.

A rise in market rates can increase the cost of the loan for the borrower and increase the interest income for the lender. Conversely, a fall in market rates can decrease the cost of the loan for the borrower and decrease the interest income for the lender.

Download your free External Analysis whitepaper that guides you through overcoming obstacles and preparing how your company is going to react to external factors.

fixed interest rate vs floating interest rate

Strategic CFO Lab Member Extra

Access your Projections Execution Plan in SCFO Lab. The step-by-step plan to get ahead of your cash flow.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

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