Have you ever searched for financial options to renovate your home, fund your children’s education or celebrate a family wedding? You most likely conducted research on banks, interest rates, tenors, etc. Perhaps you came across an option to choose between a secured loan and an unsecured loan, and did not know which one to pick. While both are equally alluring, with their own advantages and disadvantages, there are factors to consider which will help you determine the better option for you.
Generally speaking, the main difference between secured and unsecured loans is that secured loans are backed by an asset belonging to the borrower, while unsecured loans are given on the basis of the borrower's income, and do not require any upfront collateral.
Here’s a quick comparison between both types of loans:
Secured Loans v Unsecured Loans
What is a Secured Loan?
A secured loan is one in which the borrower pledges to the bank/lender as collateral, an asset of equal value to the loan amount. Examples of assets that can be pledged as security are property or cars. In case of a default on payment by the borrower, the asset will be taken over by the bank to recover the amount lent. It is important to note that at the onset of the loan agreement, the asset is only pledged to the bank/lender, and not handed over. The asset is only taken over by the bank if the borrower defaults. If all the loan payments are made on time, according to the terms, then the asset stays with the owner.
There are different types of secured loans, some of which include:
- Vehicle Loans: In this case, the loan is secured against the vehicle being purchased. For example, if you decide to upgrade to a new car, or decide to buy a fleet of cars for your business, you can get a vehicle loan and pledge the new cars being purchased as security. As long as you make your repayments on time as agreed, you have full access over the vehicles. But if you default on payment, then the cars can be taken over by the bank and sold, to recover their funds.
- Mortgage Loans: Like in the case of vehicle loans, this loan is secured against the property being purchased. The borrower can enjoy the home/property as long as they make repayments as and when due. In the case of a default however, the bank can take over the property and sell to recover their investment.
- Secured Business Loans: Here, machinery, stock, raw material, buildings etc. are pledged against the loan amount required.
Benefits of Secured Loans
- Low Interest Rates: Because of the collateral attached/pledged security, the risk to the bank is reduced and this allows them to offer relatively low interest rates for these kinds of loans.
- Higher Loan Amounts: The loan amount typically matches the value of the pledged asset, and as such, borrowers can access higher amounts than they would if they were taking unsecured loans.
- Longer Tenure: Again, the reduced risk to the bank allows for longer repayment terms to be negotiated, with consideration given to the lifespan of the pledged asset.
What is an Unsecured Loan?
Unsecured loans are given on the basis of your income, financial status, creditworthiness, character and ability to pay. In the case of defaults, the bank can only sue the individual, as there is no pledged asset or collateral to take over and recover the loan. As a result, this kind of loan is usually given to individuals who have high credit scores and a history of loan repayment.
The types of unsecured loans include:
- Personal Loans: taken for vacations, wedding expenses or for any other personal needs for which you do not have ready liquidity.
- Credit Cards: this is the most flexible form of short-term borrowing, with easy repayment options.
- Account Overdrafts: when a bank allows you to spend more than the available balance in your account, up to a certain limit.
Benefits of Unsecured Loans:
- Convenience: Especially when borrowing small amounts, unsecured loans are convenient and less risky for the borrower because of the lack of a collateral requirement.
- Quick Processing: Unsecured loans tend to be processed faster than secured loans as there is no collateral evaluation required, a process that usually takes a considerable amount of time. Your credit score and credit history can easily be accessed and evaluated, and a decision can be made within days, sometimes hours or even minutes.
Now that you know about both types of loans, which should you opt for?
Factors to consider when making a decision, include:
- Do you have any assets to pledge?
- What is your repayment capability?
- What is the end use of the finance you need? Is it commercial or personal?
- How long do you need to pay back the loan?
You should go with a secured loan if:
- You’re seeking low interest rates
- You are capable of paying over a long period of time
- You have assets you can conveniently leverage
- You have financial flexibility
And, you should opt for an unsecured loan if:
- You need immediate financial assistance, with minimal paperwork
- The loan amount is relatively small
- You don’t have an asset to mortgage
- You have a steady, predictable source of income
- You have a good credit score
The bottom line is, both unsecured and secured loans come in handy in different situations, and now you have all the information you need to choose the right option that suits your needs.