Difference Between Secured And Unsecured Loan
Thinking of taking a loan? Secured loans and unsecured loans are the two main types of loans available. Which would suit your needs best? Learn about unsecured vs secured loans before you decide.
By Amrita Gracias
In the modern economic scenario, loans seem to be the most common and easiest way to avail of financial assistance in order to pay for a variety of things – a house, a car, higher education, a wedding or even a holiday! Loans are being marketed aggressively by banks and lending institutions, and the paperwork required for loan approval is being increasingly simplified. However, it is important to be aware of the different types of loans, their implications, and their terms and conditions, so that you can make an informed choice.
There are several types of loans that can be availed of for various purposes, but they can be broadly classified as secured loans and unsecured loans.
So, what do the terms ‘secured’ and ‘unsecured’ mean in this context? And, when in need of a loan, how does one choose between a secured loan and an unsecured loan?
Secured Loans Vs Unsecured Loans
A secured loan, or a collateral loan as it is otherwise known, is one that is linked to an asset as a collateral – in other words, the borrower pledges something of value he owns to the lender, as security for the money he will be borrowing. Various types of assets can be pledged, depending on the quantum of loan required – a house, a car or jewellery, for instance. And, in case the borrower fails to repay the loan or defaults on paying instalments of the interest amount or the principal, the lender has the right to seize or ‘repossess’ the asset put up as collateral. In this case, ‘repossess’ refers to the lender taking possession of the property to which he has right of ownership by way of collateral, though the borrower possesses it. The asset can then be sold by the lender in order to recover the money lent and close the outstanding debt.
Types of secured loans include:
- Home loans (house / property as collateral)
- Mortgage loans (property as collateral)
- Automobile / Vehicle loans (vehicle as collateral)
- Loan on equipment for business or agricultural purposes (equipment or other assets of the business as collateral)
- Jewellery loans (jewellery as collateral)
- Loans taken on fixed deposits or insurance policies (deposit receipts or policy documents as collateral)
- Loans taken from pawnbrokers (anything ranging from jewellery to electronics as collateral)
Apart from the asset to be pledged as security, there are other factors that influence a person’s eligibility to avail of a secured loan. These include a regular and steady income, perceived ability to repay, credit score (based on history of repayment of past loans) and liabilities (credit card dues and outstanding loans).
An unsecured loan, or a signature loan, as it is sometimes called, on the other hand, is a loan given without collateral. This type of loan is given purely on the basis of a signed promissory note to repay the loan amount along with the agreed upon interest.
Types of unsecured loans could include:
- Personal loans
- Credit cards and loans on credit cards
- Education loans
- Signature loans
- Instant Loans
Since there is no actual guarantee (collateral) of repayment of unsecured loans, these loans are based largely on trust, the creditworthiness of the borrower and his financial capacity to repay the loan.
"The crucial factors to be considered while applying for education loan are:
• Before applying for an education loan, you should check whether the loan facility is available for the course and the college of your choice.
• Reputation of colleges/universities and popularity of courses/programmes matter a lot for sanctioning of education loans, as the chance of loan approval increases with the bank’s confidence that you will find a job in time to repay the loan.
• Before applying for education loan, you should have a clear idea of the amount required, considering all expenses and not just the tuition fee (living expenses, travelling expenses, books, purchasing laptop, other equipment, and other overhead expenses).
• Look for an education loan that suits your needs in terms of interest charged. You should be clear about interest charges, including the loan amount, any down payment, repayment tenure, and so on.
• Check with the bank if they require any security collateral or guarantor for approving the education loan. Most educational loan providers require a valid guarantor with a high CIBIL score.
• Education loan EMIs do not begin immediately after getting the loan, but start after the course is over and you start to earn.
• Education loan tenure should be long-term, depending on the size of the loan, which helps in easing the repayment burden with relatively smaller EMIs.
• Check other parameters like processing fees, legal fees, valuation fees, Keyman insurance, and stamp duty charges."
— K Satish, Director, Zen Money
Benefits of secured loan vs unsecured loan
Both secured and unsecured loans have certain advantages. Creditors, obviously, are more likely to prefer secured loans, since the collateral safeguards them against any losses that they could incur if the borrower defaults on payments.
But the borrower too enjoys some benefits from taking a secured loan. Here are some of them:
- Secured loans attract a lower rate of interest because the right of ownership of the asset given as collateral rests with the lender, thereby lowering his risks.
- Higher amounts of money can be borrowed through a secured loan as (IF) the collateral attached is of high value. The lender is more open to giving large sums since he is assured of getting his money back either when the borrower repays the amount or by selling off the collateral asset in case the borrower defaults.
- Repaying a secured loan without delays is a great way to build your credit score and rating, especially if you wish to avail of more loans in the future.
- The interest paid on loans like home loans and mortgage loans are tax deductible, allowing the borrower to claim certain deductions on the interest paid towards the loan every year. However there are certain caps as per Income Tax Act; for example, interest up to Rs 2,00,000 can be deducted.
- Secured loans allow certain flexibilities on the repayment tenure. For instance, if you get some extra money, you can use it to make a lump sum repayment (over and above the agreed upon repayment instalments); you can increase the amount of your EMIs; you can even pay an extra EMI in a year to bring down the outstanding principal of the loan amount.
- The pledging of an asset encourages discipline in repaying the loan, as the borrower is aware that defaulting puts the asset at the risk of being seized by the lender.
- Those with lower incomes, who may otherwise find it difficult to raise large amounts, are more likely to get a secured loan approved by pledging a high-value asset as collateral.
Unsecured loans also provide certain benefits to borrowers. The main one is that the borrower is not at risk of losing the collateral in case circumstances make it impossible to repay the loan on time. Here are some of the other benefits of unsecured loans:
- Since no collateral is required, even someone who doesn’t own a house or a vehicle can avail of an unsecured loan. In other words, unsecured loans are more accessible to more people.
- Since only smaller amounts of money are given as unsecured loans in comparison to secured loans, repayment can be completed faster.
- Owing to the basic features of an unsecured loan, only minimum documentation is required. This is particularly relevant when you need to borrow money urgently, to tide over an emergency.
- The approval processes for an unsecured loan is also comparatively easier. In some cases the loan is approved instantly online or over the phone, without the borrower having to even visit the lender or bank in question. This usually happens when the borrower has a high credit score and the capacity to pay back the loan without any difficulty.
"Qualifying for education loan with a secured option is easier, as it poses less risk to the lender since it is connected with an asset as collateral. To avail education loans of above Rs 7.5 lakhs, collateral security is compulsory. If the borrower fails to pay the loan, the bank can sell the collateral to repay the debt. So, one should ensure repaying the loan on time to avoid loss of asset/property that is kept as collateral for the loan."
— K Satish, Director, Zen Money
Drawbacks of secured loans vs unsecured loans
Secured loans are always beneficial from the lender’s point of view. But putting up a valuable asset as collateral can be a huge risk for the borrower. Here are some of the disadvantages of a secured loan:
- Perhaps the biggest disadvantage of a secured loan is the risk of the collateral being seized when there is a repayment problem. Borrowers face the danger of losing their home, vehicle, jewellery or whatever the pledged asset might be.
- In the case of the asset being seized or repossessed, the borrower will also have to forfeit all the EMIs he has paid until then as they are usually considered null and void under the terms of the loan. Moreover, if there is an outstanding amount even after the sale of the collateral, then the borrower’s regular income is taken by the bank or lender till the loan is paid up fully, forcing the borrower to live in debt.
- Secured loans involve a longer repayment schedule (several years) and there is thus a greater risk of not being able to repay owing to unforeseen loss in income or increase in other personal expenses due to various unavoidable circumstances, which can affect the repayment process. Fines and penalties are also levied on the borrower if there are delays in repaying the loan, sending up the debt burden.
- A longer repayment tenure also means that you end up paying a lot more than you borrowed. This holds true even though the interest rates and the cost of the EMIs are lower. Amount paid during initial years mostly go towards paying the Interest and not the Principal.
- Any delays or defaults in repaying the loan can greatly affect your credit or Credit Information Bureau (India) Limited (CIBIL) score, lowering your chances of securing future loans.
Does this mean that unsecured loans are more advantageous? Well, not really. They have their fair share of disadvantages too. Here are some of them:
- Unsecured loan interest rates are higher since there is no collateral attached to the loan and it constitutes a risk for the lender, as he has no guarantee that the loan will be repaid.
- Smaller amounts of money are lent as unsecured loans, compared to secured loans. Therefore, an unsecured loan will not be suitable when a large sum of money is required.
- Repayment of an unsecured loan doesn’t allow for flexibility such as foreclosing the loan or paying extra EMIs. Even if the terms do allow these, heavy charges are often levied, making it inconvenient and expensive for the borrower.
- It can be difficult for those with no / poor credit history or no regular income to obtain an unsecured loan since these loans are largely based on the borrower’s capacity to repay.
"For education loan of less than Rs 7.5 lakhs, there is no need of collateral security in PSU Banks. So, one can consider taking loan from public sector banks, as the interest rates are also low. However, if the loan amount is above Rs 7.5 lakhs and you don’t have any collateral, you can consider private sector banks."
— K Satish, Director, Zen Money
Key differences between secured loans vs unsecured loans
Collateral: While secured loans are granted only with a collateral asset attached as security for the money borrowed, unsecured loans are obtained without the need for any collateral as the loan is given based purely on trust and the creditworthiness of the borrower.
Risk involved: In the case of secured loans, the risk lies solely with the borrower, as his asset or collateral can be seized in case he defaults on the loan repayment. For unsecured loans, on the other hand, the lender is at risk since there is no collateral to fall back on if the borrower fails to pay back the loan.
Interest rates: Interest rates vary greatly based on the type of loan. They are comparatively lower for secured loans than unsecured loans. This is again due to the risk associated with the loan – the presence or absence of a guarantee for repayment. Interest rates for unsecured loans can increase based on the borrower’s credit position.
Purpose of loan: Both secured and unsecured loans are taken for specific purposes. Secured loans are taken mainly when the borrower wants a large sum of money at a lower cost. The reasons could include purchase or renovation of a house or property, purchase of a vehicle or purchase of equipment required for a business. Unsecured loans are usually taken to meet a sudden expense, where the amount required is comparatively low, although the loan might come at a slightly higher cost. For instance, unsecured loans are taken to meet expenses for a wedding, higher education, purchase of commodities or any other personal expenses that come your way.
Repayment tenure: Secured loans have long repayment tenures that can range from a few years to even a few decades (20 – 30 years). Unsecured loans, however, are short-term loans that usually must be repaid within one to five years.
Loan amount: In the case of a secured loan, the borrowed amount can go up to several lakhs of rupees as the loan amount is a certain percentage (up to 90%) of the pledged asset. In an unsecured loan, however, the loan amount ranges only from a few thousands to a few lakhs of rupees as the loan is based on criteria such as income or credit score.
Cash inflow and outflow: Cash outflow towards both secured and unsecured loans should never exceed 50% of cash inflow. This will help you to manage your finances and meet other requirements like running your household, saving for financial goals like children's education (or marriage) or your retirement.
Contingency fund: As we live in a VUCA (Volatile, Uncertain, Complex and Ambiguous) world, it is a good idea to save 6 months of your expenses in fixed deposits.
Interest earned Vs paid: When we take a secured or unsecured loan, we pay an interest; for example, annual interest on credit card loan could be as high 36% per annum. So, before taking a loan, take stock to see if you would earn that interest from your other assets (such as gold (or) fixed deposits). If the answer is No, then sell the assets instead of going for high-cost loans, as you would end up working for the Banks / Financial Institutions / Lenders.
"The differences between getting a loan from NBFC and from a PSU bank are:
• The interest rates of PSU banks are lowercompared with NBFCs.
• PSU banks offer secured loans, while NBFCs offer non-collateral education loans.
• PSU banks offer a payment-free moratorium period which includes the duration of the course and 6 months after that. This can be extended for another 6 months. While in case of NBFC education loan, EMIs start from the next month after the loan disbursement.
• Processing fees are higher in NBFCs compared to PSU banks.
• The loan processing time of NBFCs is lower (1 week),compared to the 15 days taken by PSU Banks.
• If the co-applicant’s credit score is low due to genuine reasons, PSU banks will accept such profiles, whereas the NBFCs wouldn't.
• Loan insurance is not compulsory for PSU banks. But, NBFCs insist the loan applicants should take insurance."
— K Satish, Director, Zen Money
So which type of loan is more suitable for you – a secured loan or an unsecured loan? One cannot arbitrarily say that one is better than the other. You need to consider your own specific needs for the loan, weigh the pros and cons of both options and then make an informed choice. Keep in mind various factors that will influence the approval or rejection of the loan request. And, most importantly don’t forget to check various risks associated with the type of loan you are intending to avail of. Ensure that you have the means to repay the loan.
With the information that we have provided, you are empowered to choose wisely! Good luck!
About the expert:
Reviewed by Dr A V Senthil on 18 September 2019
Dr A V Senthil is a seasoned wealth & IT professional who works closely with clients to build, manage and protect wealth effectively and efficiently.
About the author:
Written by Amrita Gracias on 22 August 2019; updated on 18 September 2019
Amrita Gracias holds a degree in English Literature from Stella Maris College, Chennai and a Post Graduate Diploma in Journalism (specialising in Print Media) from the Asian College of Journalism, Chennai. She takes to writing and editing when she isn’t answering to the duties of motherhood!
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