Banks and financial institutions offer loans in two basic categories: secured loans and unsecured loans. Understanding the distinction between the two is a critical step towards acquiring financial literacy, which can have long-term consequences for your financial health.
A secured loan requires borrowers to provide collateral or security in exchange for the loan, whereas an unsecured loan does not. The difference has an impact on your interest rate, borrowing limit, and payback conditions.
There are advantages and disadvantages to choosing a secured loan over an unsecured loan, which is why we have emphasized the differences.
What is a Secured Loan?
A secured loan is a loan that requires you to provide security, which is tangible security appropriately charged to the bank and excludes intangible securities such as guarantees to the lender if you want to borrow money from them. Banks accept real estate, automobiles, securities, jewels, and other assets of great monetary worth as collateral.
Secured loans typically provide borrowers with a cheaper interest rate and more flexible borrowing conditions. This is because collateral-backed loans are typically less risky for lenders because they are guaranteed to be repaid.
However, life is unpredictable, and you may find yourself unable to make the monthly EMI payment. If you fail to make EMI payments on a secured loan, the lender has the legal authority to seize the collateral. This is done so that the lender can recoup the money you owe them. Fortunately, lenders often allow you three months to clear all of your defaults and get back on track with your EMI payments.
Where can I obtain a secured loan?
Banks, credit unions, and online lenders are among the financial entities that provide secured loans.
Advantages of Secured Loans
- Eligibility restrictions are less severe.
- Frequently have cheaper interest rates than unsecured loans.
- Borrowing restrictions are higher than for unsecured loans.
The Disadvantages of Secured Loans
- If you default on the loan, collateral may be taken.
- Failure to return the loan on time can harm your credit.
- There are usually limitations on how the funds can be used.
What is Unsecured Loan?
When you take out an unsecured loan, you are not required to offer any tangible security to the lender. Because of the lack of security, these may have higher interest rates than secured loans. The creditor approves your loan primarily based on your ability to repay the obligation. This is accomplished by reviewing your bank account statements and CIBIL score, among other things. Having a steady source of income can make it easier to obtain an unsecured loan. Banks will also evaluate your employment history and references when considering your application for an unsecured loan. Lenders also analyse your monthly income along with your previous loans. This enables them to appropriately assess your financial capacity to repay the loan.
Unsecured loans are ideal for people who need to borrow money but do not have any collateral to put up. As a result, even if you do not own a home or jewellery, you can still obtain the funding you require.
Where to get an unsecured loan
Unsecured loans, like secured loans, are available via a bank, credit union, or internet lender.
Advantages of Unsecured Loans
- If you default on your debt, a lender cannot seize your assets unless the court orders it.
- There is no need for collateral.
- Flexibility in how you can spend your money.
The disadvantages of unsecured borrowing
- Interest rates on unsecured loans are frequently higher than on secured loans.
- Some lenders may charge up to 10% in origination costs.
- With bad credit, it may be difficult for them to qualify.
- Defaulting on the loan can have major consequences for your credit.
Difference Between a Secured and an Unsecured Loan?
- The main difference between a secured and an unsecured loan lies in the collateral required to secure the loan. To secure a loan, you must furnish the lender with an asset to serve as collateral. Conversely, obtaining an unsecured loan does not necessitate providing an asset as collateral.
- Differing in interest rates is another crucial distinction between secured and unsecured loans. Generally, secured loans boast lower interest rates, attributed to lenders perceiving unsecured loans as riskier.
- Secured loans are easier to obtain than unsecured loans since it is less risky for a banker to make a secured loan.
- With longer repayment terms than unsecured loans, secured loans generally offer borrowers a more advantageous arrangement for repaying the loan.
- Obtaining secured loans is relatively easier due to lower risk for lenders, whereas acquiring unsecured loans presents more challenges.
How to settle debts, both secured and unsecured
Having a plan to pay off debt, whether secured or unsecured, can be beneficial.
As part of any plan, it is critical to make at least the minimum payment on all debts. However, it may make sense to pay extra money towards secured debt to avoid losing collateral, especially if that collateral is a property or a car. If you’re worried about rising interest rates, it can be a good idea to prioritise unsecured loans to avoid paying more in the long run.
The Consumer Financial Protection Bureau (CFPB) suggests two options for repaying secured and unsecured debts:
The snowball method
Paying down your smallest debt first is the debt snowball strategy. Make a list of all your secured and unsecured debts and rank them in order of how much you owe. Make the minimum payment on all debts except the smallest. Then, allocate more funds in your budget to the smallest debt. Once you’ve settled it, move on to the next smaller debt using the snowball method.
The debt avalanche strategy is referred to by the CFPB as the “highest interest rate method.” This technique focuses on high-interest debt first. Make a list of all your debts to begin. Then, sort them by interest rate, from highest to lowest.
Except for the one at the top, pay the minimum on each debt. Then, as with the snowball method, apply the remainder of your planned funds to the debt with the greatest interest rate. Once you’ve paid it off, apply the avalanche strategy to the debt with the next highest interest rate.
Another alternative is to refinance your debt or use a balance transfer to consolidate or simplify payments. However, make careful to investigate the total cost of transferring a debt as well as interest rates. Transfer fees, for example, could make consolidation more expensive.
Speaking with a financial advisor before making any decisions could help you make the best choice.
Finally, whenever you need money, you should ask your bank or financial institution for both secured and unsecured loan possibilities and compare the terms. If you possess a property that can be used as collateral, a secured loan may be a lot less and make your monthly outgo reasonable. You must, of course, consider the time frame in which you require the loan, as secured loans often take longer for a bank/financial institution to process than unsecured loans.