Finance

Secured vs. Unsecured Loans in a Nutshell

Taking out a loan can feel like a big decision and it is! Often, an offer comes in the mail for a loan and we just go for it, since it sounds like a great way to make larger purchases. But before you jump at the opportunity, you should first do quite a bit of research. Figure out what types of loans are out there, how to apply for them, what are good and bad loans, understand your bank’s lending rules and have an idea on how you will pay them back. One important consideration to keep in mind is whether you are taking out a secured or an unsecured loan. Below, you’ll find the list of the main differences between the two.

Collateral

One of the most obvious differences between a secured and an unsecured loan is collateral. Or rather, the fact that secured loans are given out under collateral, while unsecured loans are not backed up by any. So, for example, if you are applying for a home loan or a car loan, this will likely be a secured loan, where if you don’t pay your loan, the bank or the lender will take ownership of the property or the vehicle. Meanwhile, an unsecured loan is based on your creditworthiness alone, and if the bank doesn’t receive payments, they can sue, but there isn’t security that they can collect per se.

Interest Rates

An interest rate is a percentage that you pay on top of the base amount when returning a loan. It’s kind of like the price of purchasing a loan from the bank. It is calculated based on a number of factors, including the current economy, general rates set out by the central banks, credit laws, but also the risk that the bank runs when loaning the money. As such, a secured loan will typically cost less, meaning it will have lower interest rates. On the other hand, you might see very high interest rates on a personal loan.

End-Use

Another important difference is that secured vs unsecured loans have different levels of flexibility. A secured loan, since it’s available under specific collateral, usually entails spending it on the purchase of that collateral, or at least the majority of it. An unsecured loan basically gives you liquidity instead. You can take an unsecured loan and spend it on whatever you wish – furniture for a home, clothes, travel, education, etc.

Application Process

While there are many benefits to taking out a secured loan for a large purchase, the application process may not be one of them. It tends to take a lot of paperwork, time and effort on your part. This is because it is usually a larger sum of money and there are various checks that the bank needs to perform. Additionally, there are legal papers that must draft to ensure collateral. When it comes to an unsecured loan, the application process will typically be rather simple. You will just need to fill out a few forms and if the bank deems that your credit score is high enough, it will give you a loan.

Repayment Timeframe

The amount of time that you have to pay out each of the loans will also differ. Because a secured loan is generally a big investment, with a high price tag, it also gives you more time to pay that money back. It can be years or even decades before you have to settle the entire loan and you will normally follow a specific payment plan over the course of these years. Meanwhile, an unsecured loan will rarely be given to you for longer than 5 years, and generally lasts anywhere between 1 and 5 years. Over this time, you’ll need to repay the sum of money that you took out plus the interest rate that the bank established upon signing for the loan.

Credit Score

This is a very important difference to consider when choosing to take out a loan. Your credit score evaluates the type of credit that you have in the way that your score is rated. If you have only unsecured loans, then your CIBIL Score is likely to go down. It is advisable to always have a good mix of secured and unsecured loans in your portfolio, which will then report favorably on your creditworthiness. This is typical because a secured loan is a safer option for a bank and demonstrates that you own property or other valuable items, compared to an unsecured loan.

The bottom-line is that both secured vs unsecured loans have their place and time. There isn’t really one that is better. It depends on what you are borrowing money for and how you plan on repaying it. That said, it is essential to understand the differences between how the two work and what they entail in terms of interest rates, your credit score, the time you have to pay them back, how you are able to use them. Usually, when you are looking to borrow a larger sum of money, it is a good idea to talk to your financial advisor and do some personal research before you make a decision on the best loan options to suit your personal needs. This will both arm you with information, but also make the process less stressful, in addition to helping you make sound financial decisions.