SECURED V/S UNSECURED LOANS - WHICH LOAN IS RIGHT FOR YOU

Secured and unsecured loans have recently emerged as the go-to means for both salaried and self-employed individuals to fulfil their financial needs. One of the primary reasons fuelling this rise in popularity of loan is the ease of access. But before you apply a new loan, you must know the difference between a secured and an unsecured loan.

Read on to understand which loan is right for you. 
 

What is a secured loan?

Secured loans are the loans where lenders ask you to provide for guarantee or security against the money they are lending. In banking terms, this guarantee is called collateral. This collateral can be any asset, from your property to car to jewellery, which the lender can sell to recover their money, in case you fail to repay the loan. It is easier to get this type of loan sanctioned. It is ideal for people with not so good credit history.
You can also prefer a secured loan over an unsecured loan because of low interest rate. However, the paperwork associated with a secured loan is much more complicated than unsecured loan.
 

Types of secured loan

 

• Loan against property

  This kind of loan requires you to submit the papers of your home or real estate property as mortgage. Since the property cost is often very high, not repaying the loan could result in a huge loss to the borrower. Also, you must make sure that your property is in good condition and the paperwork is complete.
   

• Auto loans

  In auto loans, the vehicle you are buying with the loan itself becomes the collateral. In case you fail to pay the loan EMIs, the lending institute reserves the right to confiscate your vehicle. Example of such loans is two-wheeler loans, used car loans, etc.

 

• Invoices

  With this type of loans, financial institutions pay you in advance as you wait for your payments from your customers, which lenders can then collect on your behalf.   
   

• Medical equipment financing

  This is a type of equipment loan that is available only to licensed medical practitioners or those who own or operate a hospital or diagnostic centre. This loan can be used to purchase X-ray machines, city scan devices, dialysis technology, and other medical devices. Machinery loans can be repaid over a 7-year period at an interest rate starting at 11%.
   

• Working Capital Loan

  This loan is backed by the underlying inventories in your company. Working capital loans provide significant funding and must be repaid within three years. You can use this loan to meet your company's operational needs.
   

Factors affecting secured loan

 

• Debt-to-income ratio

  The lender assesses how much of your monthly earnings go towards repayment. If this ratio is below 40 and the application is for substantial funding, the lender will simply reject your application.
   

• Property condition

  The lender will examine the asset/vehicle condition if the loan involves the mortgaging of real estate assets or the hypothecation of a used car. You will not be approved for a loan if it is not in good condition. In case the collateral is investment papers, the time left to maturity becomes crucial. The lender will not accept any such investment if the time remaining until the loan's maturity exceeds the time remaining for your investment.
   

Weighing the pros and cons of a secured loan

 
Before you decide to apply for one, you might want to consider the pros and cons of a secure loan. So here we go:
 

Pros

1. The rates of interest for a secured loan are lower since they are backed by a property.

1. You don’t need to worry about a perfect credit rating. This does not mean your credit ratings are not important. If your ratings are not that great, the rates of interest will be higher.

1. You can borrow a higher limit even though the loan amount.

1. The repayment time is much longer so you can opt for a long tenure and bring down your monthly EMI burden.

 

Cons

1. If you don’t pay up the loan amount, you could end up losing your collateral.
2. Since you will have to submit the papers of your property, the paperwork can seem a bit cumbersome.
3. Secured loans leave you in a debt trap for a long time since the repayment terms are longer. If you want to pay off the loan early, lenders usually charge fees.

 

What is an unsecured loan?

An unsecured loan is a loan that requires no collateral. The loan is issued on the basis of the borrower’s creditworthiness, which is evaluated by the 5 Cs – character, capacity, capital, collateral, and conditions. Since there is no collateral in unsecured loan, the borrower must meet the expectations in other categories. Generally, it is tough to get approvals for such loans as the element of risk for the lender is quite high. And because of this risk, lenders levy higher interest rates and offer smaller amounts of capital with smaller repayment periods.
 

Types of unsecured loan

 

• Credit card

  The very common yet empowering credit cards in your pocket is actually a type of unsecured loan. Every time you swipe a credit card, the lender basically gives you an unsecured loan. The credit limit depends on the user’s creditworthiness. The interest rates on your credit card are usually high. In case of any late pay or defaults, you will have to bear the penalties on late payments.
   

• Personal loan

  A personal loan can be availed for any reason. This is an unsecured loan that relies on goodwill, positive income-debt ratio, and good credit history. You can easily avail a personal loan from a bank or non-banking financial institute. The interest rates on personal loans are usually lower than credit cards. But you need to be regular with your EMIs.
   

• Business term loans

  They are commercial loans that entrepreneurs can use to fund their business expenses. The lender provides funding for a maximum of Rs 250,000 through this product. This loan can be repaid over a period of 12 to 36 months. A business loan can be used for a variety of purposes, including payment of employee salaries, purchasing new equipment, paying taxes, and much more.
   

Factors affecting Unsecured loan

 

• Credit report

  Since these are non-collateralised loans, the lender expects you to have a report with no record of debt defaults, EMI skips, or loan settlements.
   

• Income

  You must have a decent income that reflects your repayment potential. 
   

• Age

  You must be under the age of 60, as retirees typically do not have any earning potential and have a high risk of default.
   
   

Pros and cons of unsecured loan

Let us look into the advantages and disadvantages of this type of loan.
 

Pros

1. The biggest benefit of unsecured loans is that there is no need to submit an asset to the bank. With no asset at stake, the risk of losing your collateral is absent. Hence it is best suited for small amounts of money which the borrower is confident of paying as soon as possible.
2. With numerous lenders willing to offer unsecured loan, the application process is usually simpler and faster. In short, you get your loan faster.
3. The papers required for an unsecured loan is usually minimal. You just need to submit your KYC, income proof and other documents requested by your lender.

 

Cons

1. Since the risk involved is very high for the borrower, unsecured loans are usually small in amount.

1. Since there are no collaterals to back up the loan, the interest rates are very high for unsecured loans.

1. You need a good credit history and a stable financial condition. This is because the lender will need some assurance that he will get his money back. So, not everyone is eligible for a personal loan.

 

Which one is right for your business?

 
While most experts rate secured loans highly because they are easier to get and get the borrower several favorable terms, there is no definitive answer for which loan to opt. It differs from individual to individual. For those who do not want to risk putting an asset on the line and are confident about their repayment ability, they can opt for an unsecured loan for smaller amounts. However, the bottom line is that a healthy credit score is a must for both and in both cases, the borrower may end up losing his/her assets if he/she defaults on the loan. 
 
Disclaimer: This post was first published on 16th November 2018 and has been updated for the latest information, freshness and accuracy