While shopping for a personal loan, aspiring borrowers find two main types of loans – secured and unsecured. Secured loans are backed by collateral, which means borrowers pledge a valuable asset they own as security, such as property, in case of a default. However, an unsecured loan does not require any such guarantee or collateral for approval. Both types of loans have their pros and cons. With the growth of unsecured personal loans that several NBFCs offer these days, their demand is constantly growing among borrowers.
With so many loan options available out there, deciding on the best loan plan becomes complicated. Gathering some crucial facts about secured and unsecured loans would be the best first step in making a loan application.
Understanding Secured and Unsecured Loans
What is a Secured Loan?
Borrowers often take secured loans for big-ticket purchases like industrial machines or luxury cars. Loan seekers with good credit scores can obtain them at very low-interest rates due to assure repayment for the lending institution. Most lending institutions feel safer lending secured loans because they involve less risk of default. That is why they offer a secured personal loan at lower interest rates than an unsecured one.
What is an Unsecured Loan?
An unsecured loan does not require any collateral, security or guarantor. However, failing to repay the loan on time results in a poor credit score. The loan provider may also send a collection agent to the borrowers if they do not pay off their loan according to the loan agreement.
How Do They Work?
How Does a Secured Loan Work?
Borrowers pledge an asset to get a secured loan. At times, when they use the loan to purchase an expensive item, the item itself might serve as collateral. The lending institution holds its title or deed until the borrower repays the loan in full. Borrowers can also use other assets to back a secured loan, such as property, stock, gold, or bond.
A secured loan is the most common funding option to borrow lump sum amounts for significant purchases. The borrower signs an agreement to repay the loan in full within the loan period. Putting an asset as collateral is a way to ensure timely payments. Apart from big purchases, borrowers can also use a secured loan for home equity or a home equity line of credit. It means providing security for timely repayment. However, the risk is that if the borrower does not repay the loan as agreed, the loan provider can sell the asset to recoup their money.
How Does an Unsecured Loan Work?
An unsecured loan is the reverse of a secured loan. They include credit options like education loans, personal loans, and credit cards. Financial institutions take more risk by lending these loans, as they do not have any assets to recover their money in case of a default. That is why they come at a slightly higher interest rate. That means if a loan company turns an applicant down for an unsecured loan, they can still obtain a secured loan. However, they must provide something of value to serve as collateral.
An unsecured loan provider believes in the borrower’s promise to repay the loan on time, based on their financial resources. They make their lending decision based on these five C’s of credit:
- Character, including the borrower’s references, credit score, and employment history
- Capacity, based on the applicant’s income and debt-to-income (DTI) ratio
- Capital, including money in investment accounts and savings
- Collateral, personal assets of the applicant, like a residential or commercial property
- Conditions, referring to the loan terms and requirement
These are the yardsticks to assess a borrower’s repayment capability and might include the borrower’s economic factors and financial situation.
Key Points of Differences Between Secured and Unsecured Loans
The final choice between a secured and unsecured loan impacts an applicant’s approval chances, interest rates, processing charges, and other loan terms and conditions. Here are a few key points of differences between the two:
- Collateral: The most important difference between the two loan types comes down to the collateral requirement. A secured loan gives the NBFC the right to foreclose the collateral and sell it to recover the borrowed amount with interest. However, an unsecured personal loan does not involve any asset as security. Still, a defaulter has to face implications in the form of late payment charges, poor credit scores, and collection in their credit report.
- Interest Rates: It is easy to find a secured personal loan for lower interest rates because it involves less risk for the NBFCs. Similarly, unsecured loans have slightly higher interest rates due to the higher risk the lending institution takes by approving such loans. However, those with a good credit score of above 630 can still get favourable interest rates on either loan type.
- Borrowing Limits: Unsecured loans have smaller loan sizes due to more risk for the lender. On the other hand, the sanctioned amount of a loan sanction depends on the collateral value. Most reputable lending institutions lend up to a significant percentage of the asset’s market value as a loan, giving borrowers easy access to larger amounts.
Which is Better – A Secured or an Unsecured personal loan?
The final choice between a secured and unsecured personal loan depends on the loan seeker’s funding requirement, credit score, and financial situation. Since one can easily borrow a secured personal loan at lower interest rates and bigger loan sanctions, they are better options for those confident about timely repayments. Besides, they are better options for loan seekers with poor credit scores. On the other hand, unsecured loans are the best choice for aspiring borrowers who do not want to place their assets at risk. Although the interest rates are slightly higher, they can still get competitive rates if they have a minimum credit score of 630 or above.
Both secured and unsecured loans have distinctive features and benefits. While an individual may avail of a personal loan at lower interest rates, they may lose their asset if they default. With unsecured personal loans, the interest rates may be higher, but there is no risk to the assets a borrower already owns. Whether an individual decides to borrow a secured or an unsecured personal loan, they must shop around and compare loan conditions to ensure getting the best rates for their financial need.