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?
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.
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.
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.
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:
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:
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:
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:
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.
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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