Do you need to take a loan to pay for your home renovation project or a big-ticket purchase? When talking about loans, it is important to choose one that meets your financial requirements and falls within your repayment capacity.
To help you make an informed decision, in this article, we will talk about how secured and unsecured loans work. We will also take a look at their advantages, disadvantages, and other related aspects that you will need to consider.
What is a Secured Loan?
A loan that is obtained against a collateral is called a secured loan. Banks accept valuable commodities like car, property, shares, among others to disperse loans.
How does it work?
Secured loans are issued against an asset. Your bank will hold the title of the collateral until you repay the full amount. If you are looking to buy a new car or home, the purchased item will serve as collateral. You can also submit stocks, shares, and any existing property that you hold. In the event that you fail to repay the loan, your lender will take full possession of the collateral.
Examples of secured loans include car loans, home loans, and at the time, personal loans.
From the Bank’s Point of View
Banks consider secured loans as low-risk lines of credit. If you are unable to repay the borrowed the amount, your lender will use the collateral to cover their loss.
Secured loans are ideal if you don’t have an existing credit history. Banks may overlook a relatively low credit score when you take a loan against collateral.
What is an Unsecured Loan?
Unsecured loans are credit lines that are issued without a collateral. Banks take into account factors like credit history, employment and income details, and others before deciding on your eligibility.
Example of unsecured loans includes personal loans, student loans, and credit cards.
How does it Work?
Unsecured loans are issued solely based on your credibility as a borrower. Since you don’t have to put up a collateral, banks are more likely to carry out a detailed assessment of your credit history.
If you don’t repay the loan, banks can put your account into collections after exhausting all other avenues. Debt accounts are sold to collection agencies who will then attempt to recover the money from you.
From the bank’s point of View
Unsecured loans are not protected by an asset. Banks consider them to be a greater risk, and as a result, the interest rate associated with them is always higher.
You can opt for an unsecured loan if you have an established line of credit and don’t want to take the loan against a collateral.
What are the Major Differences between a Secured Loan and an Unsecured Loan?
Now that we know what secured and unsecured loans are, let us take a look at some of the differences that are important from a borrower’s perspective.
The Risk Factor
Taking a loan is always a risk, but how do these two types of loan compare?
The risk of taking a secured loan is higher because of the associated collateral. If you have put up your home to take a loan, the bank can foreclose the asset if you are unable to repay the amount.
It is less risky to take an unsecured loan since there is no collateral attached to it. Although non-payment will reflect on your credit report and make it difficult for you to apply for a new loan.
Banks have a set rate of interest for all types of loans, but for a secured loan, the interest rate is generally lower. The collateral that you put up is taken into account while determining the rate of interest you will have to pay.
The rate of interest associated with unsecured loans is usually on the higher side because banks don’t have any protection against non-payment. This is one of the reasons why the interest on your credit card is higher than your home loan.
One way of getting a low-interest unsecured loan is to have an excellent credit record. Banks could be convinced to lend you the money at a lower turnaround if you prove to be a reliable investment.
Do you need to borrow an amount that is greater than what you are eligible for? You could be approved a higher amount if you take the loan against a collateral. Generally, banks are willing to extend a higher credit if your collateral has high market value.
Banks refrain from approving huge amounts when it comes to unsecured loans. The amount is decided on your payment history, income, and the number of open credit lines you hold.
The general rule that banks follow is that your total monthly payments must not exceed 30% of your income. If you are paying more than 30% of your salary towards loans, your application might be rejected.
Control Over Funds
Since secured loans are issued against the security of an item to be purchased, the bank will have a say in how you use the money. Funds from a home loan cannot be used to pay for your medical bills. Similarly, you can only buy a car with an auto loan. Moreover, the banks will make the payment directly to the car dealership, and not to you. This places a considerable restriction on how you can use the money.
You have complete authority on how you to use the funds from an unsecured loan. Banks normally do not put any restrictions the purchases that you can make with a personal loan.
Rights over Purchased Items
Your bank can claim ownership of any item that you buy with a secured loan, like your car. The claim extends until you repay the full amount. Your creditor can place restrictions on what you can and cannot do with the collateral. Although different banks have different agreements, you will not get full ownership until you pay off the loan.
Anything that you buy with the funds from your personal loan or with your credit card will solely belong to you. Your bank does not have any claim over the item purchases. In addition, you have all the rights to use the item as you please. For example, if you decide to buy a phone with your credit card.
Banks do not entirely depend on your credit history to determine your eligibility for a secured loan. They take into consideration the valuation of your collateral and your credit score. This works well if you don’t have a good credit rating.
Your eligibility for this type of loan is entirely dependent on your creditworthiness. Your score, employment details, income, and personal expenses play a major role in assessing whether you get the loan or not. Approval also depends on the economic conditions and the financial situation of your bank.
Which One is Ideal for You?
The type of loan that you should apply for directly depends on your current financial situation and the purpose of taking the loan. Let’s consider different scenarios to see which type of loans could work well for you.
If You Don’t Have an Asset
If you don’t have a valuable commodity that you can put up as collateral, your best option is to apply for an unsecured loan. You could look at various credit cards offered by banks or compare different personal loans to find one that meets your financial requirements.
Poor Credit Score
Have you made late payments in the past? If your credit report has negative remarks, it can be difficult to apply for a loan. But you have a better chance of getting approved for a secured loan than an unsecured loan.
You Cannot Keep Up with the High-Interest Rate
Do you need a loan, but aren’t sure if you can keep up with the interest payments? In this case, a secured personal loan is your best bet. They are available at a lower rate of interest, and usually, a longer tenure. This gives you enough time to pay off the loan while making sure that your monthly payments are low.
Taking a Loan for Personal Use
Do you want to apply for a loan to pay for your holiday? An unsecured personal loan does not usually place any restrictions on how you can use the funds. You choose to pay for a holiday, fund a business idea, or spend it on home appliances and high-end fashion.
While speaking about purchases, if you want to buy a home or car, it is better to opt for a secured loan because they offer better terms and conditions. Specialized loans, like a car or home loans, are available to help you buy those specific items.
Now that you have a clear understanding of how secured and unsecured loans work, and how they differ, you need to put in the work and figure out which one works for you. It is important to understand your current finances, potential future finances, and terms and conditions of the loan before you apply. You can refer to comparison sites that’ll help you find the ideal financial product.