Difference between Secured and Unsecured Loan

Difference between Secured and Unsecured Loan

Borrowing money from a bank or an individual is considered a loan. The lender allows you to borrow their money, with a formal or an informal promise to pay it back as the basic terms. However, there could be times when the lenders require you to mortgage an asset as a security to pay back the loan. When talking about a loan, it can be divided into two broad categories – Secured and Unsecured loans. Both of them have the same fundamental principle. Still, in terms of characteristics, there is a vast difference between secured and unsecured loans in terms of how much you can exactly borrow and how much interest you are liable to pay. 

Secured Vs Unsecured Loans

 As stated above, the loan can be categories into broad types – secured and unsecured loans. Hence, one should always know the difference between a secured and unsecured loan. When you are on a path to understanding financial literacy, knowing what the two terms mean will significantly impact your entire financial health. 

 In most layman terms, a secured loan is one that requires the borrower to submit collateral. On the other hand, an unsecured loan is just the opposite of it, as the borrower is not expected to offer collateral. Hence, this difference has a significant impact on three major things, which are:

  • Interest rate
  • Borrowing limit
  • Repayment terms

There are both pros and cons when boiling down to secured vs. unsecured loans. Hence, to help you further, we have in detail explained the difference between secured and unsecured loans along with a secured loan example and an unsecured loan example. 

What are Secured Loans?

As the name ‘Secured’ suggests, secured loans are the one which is always the safest option for the lender as an asset backs these loans as a mortgage, which acts as a guarantee of the repayment of the loan. In terms of the secured loan, the borrower will have to offer collateral that can be claimed by the lender in case if the borrower defaults to pay.

The different items which can be treated as collateral are – House, car, jewelry, etc. Other items that can come under the collateral category, such as – bonds, stocks, or personal items. The lenders have the legal authority to hold these assets or titles until they do not repay the loan. 

In terms of popularity, hands down secured loans are the most common ways of lending a huge sum of money. A lender is given a large sum of loans only with a promise that the loan will be repaid within a stipulated time frame. When the lenders repossess the property, they sell this property and use the amount they receive to pay off the loans.

In case if the property is sold for a lesser amount in comparison to the actual loan amount, then the lender will be the one who will be responsible for paying the difference amount.

However, an important point to note is that secured loans are not just meant for new purchases. Secured loans can vary from home equity loans to home equity lines of credits. These are primarily based on the house’s current value, excluding the amount which is still owed.  

Hence, to sum it up, a secured loan means that the borrower provides a guarantee to the lender that he or she will repay the loan. Here, there is a considerable risk for the borrower; if they do not end up paying the loan, they could lose the asset which has been mortgaged.

Features of Secured Loan:

  1. Helps in Borrowing More Money: A secured loan is generally taken for a high amount, and the collateral for the same will also be a high-value item such as a house or a vehicle. Hence, if you own collateral of very high value, then you can always get qualified to get a large sum of money. 
  2. Longer Schedules of Repayment: The repayment schedule tends to be a little longer for the secured loans. A typical loan duration for a secured loan starts from 5 years and can go up to 30 years. 

Advantages of Secured Loan:

  1. Lower Interest Rate
  2. Longer schedules for repayment 
  3. Helps in improvising the CIBIL score, if you pay your loan timely 
  4. Higher limits for borrowing

Disadvantages of Secured Loan:

  1. In case if you fail to pay the loan amount, you will lose your precious collateral. 
  2. Failure of payment could result in a lower CIBIL score. 

Examples of Secured Loan:

  1. Mortgage: A mortgage is generally used to pay a loan for a home. The monthly payments if the mortgage includes principal & Interest + taxes & Insurance.
  2. Auto Loan: People take the auto loan when they have to purchase a car, and they can get access through an auto loan via the dealer, bank, or a credit union.
  3. Home Equity Line of Credit: HELOC (home equity loan or line of credit) allows the borrower to lend money using the home’s equity as collateral.
  4.  Recreational Vehicle Loan: This is an unusual kind of secured loan, which is to be paid for a motorhome. It many times does cover a travel trailer as well.

 

What are unsecured loans?

Unsecured loans are the total reverse of the secured loans. As compared to the secured loans, unsecured loans are more popular and are widely used. In the case of an unsecured loan, there is no need for collateral. Hence, naturally, the lender is at a higher risk in this case. Lenders end up taking more risk because there is a lack of an asset to recover the loss in any default. Hence, the lender has no access to seize the property, as he or she has in the case of the secured loan.

In the case of an unsecured loan, the interest rates are higher because even if the borrower ends up defaulting to pay the entire loan amount, the lender will still recover the loan amount. Few prominent examples of unsecured loans are credit cards, personal loans, education loans, etc.  

 As per the unsecured loan lender’s belief, the loan can be repaid due to the highly stable financial resources. Hence, he or she is ready to take that risk. A lender judges the borrower on five C’S of credit, which are:

  1. Character: This includes the credit score, references, and employment history.
  2. Capacity: This includes the current debt and income.
  3. Capital: This includes the money which is in the saving accounts or investment accounts.
  4. Collateral: This includes the personal assets offered as collateral, such as a house or car.
  5. Conditions: This includes the loan terms

 The above are the yardsticks that are used to assess the borrower’s ability to pay the debt, which takes into account the general economic factors and the situation of the borrower.

Features of Unsecured Loans

  1. Smaller loan amounts: Apart from the student loan, all the other loan types which come under the unsecured loan are small amounts. However, the Interest charged and the balance due are higher in an unsecured loan than a secured loan.
  2. Higher Interest Rates: Interest rates tend to be higher. An approximate value of the average credit card interest rate ranges from 15-18%, and the payday loans can cost about 300-400%.

 

Advantages of Unsecured Loans

  1. These loans are more convenient as it is easy to qualify for them. 
  2. These loans can help individuals buy things when they are short on cash.
  3. The best way to improve your CIBIL score is by repaying the unsecured loan amount timely. 
  4. It can help you qualify for higher amounts and low-interest rates in the future. 

Disadvantages of Unsecured Loans

  1. Higher interest rates, which could as an added burden on the borrower.
  2. Any default in the repayment can affect the CIBIL score negatively.

Examples of Unsecured Loans

  1. Student Loans: Student loans are primarily taken to pay the fees of school or college, and this loan is available through private lenders and the education department. Although student loan is considered one of the most in-demand unsecured loans, there are tax returns garnished to pay back the unsecured loans.  
  2. Personal Signature Loans: These are the types of loans used for multiple purposes and can vary from a few hundred to thousands of dollars.
  3. Credit Cards: Although there are multiple credit cards such as VISA cards, Master cards, etc. Generally, credit cards bill once a month and end up charging Interest if you default the payment within a stipulated time frame.
  4. Personal Lines of Credit: This is very similar to a type of credit card; a personal line of credit has a specific limit that can be used. This credit line can be used for anything, and the Interest is charged only on the amount spent.

 Making the Apt Financial Decision: 

 No doubt, borrowing money can be challenging as you need to be aware of various things, such as borrowing money and where. Depending on the situation, you should make a decision.

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