One of the dilemmas of an intending borrower is the issue of collateral to be used to secure the loan facility from the bank. A bank customer either a new or existing borrower needs to understand the differences between the types of loans and options that are available to him before you approach your bank. There are 2 common types of loans: secured and unsecured loans or in the alternative, loans with collateral and loans without collateral
Quick Definition of Secured and Unsecured Loans
A secured loan is a loan in which the borrower pledges some asset, like a car, home, or other valuable property including cash as collateral for the loan. It then becomes a secured debt owed to the bank or creditor who gives the loan. The debt is thus secured against the collateral. If the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally loaned to the borrower including interest that has accrued on the loan. Example of secured loans includes Mortgage, Home Equity Finance, Asset Finance, Auto loan, Term loan, Secured overdraft, Cash backed facility,
An unsecured loan, on the other hand, refers to any loans that are not secured or collateralized by a lien on specific assets of the borrower in the case of failure to meet the terms for repayment. Examples of unsecured loans include Personal Loans against salary, Student Loans, Travel loans, Salary Overdrafts, Payment Against Uncleared Effects, Stock Replacement Facilities, LPO Finance, Invoice Discounting Facilities, Import Finance Facilities, Margin Loans, and so on
To have a more distinct differentiation between the two types of loans, however, we will have to look at them from the under-listed thresholds.
- Loan Purpose
- Borrowing Limit
- Tenure
- Interest Rate
- Approval Process
Loan Purpose
Loan Purpose refers to the reason you have approached your bank for a loan. It is either for personal finance reasons or for business finance reasons. Most Secured Loans whether for personal or business are borrowed to finance long-term projects and comfortable living: Mortgage, Auto Loan, Project Finance, Asset Finance, Term Loan, and so on. While unsecured loans are generally borrowed to take care of business or personal opportunities that have short gestation or payback periods.
Borrowing Limit
The borrowing limits, which refer to loan amounts are always higher for secured loans than those for unsecured loans because of the presence of collateral for secured loans. Banks are more comfortable with secured loans because customer has pledged their assets as security/collateral for the loan hence the longer payback period. The limit will, however, varies from one bank to another with most banks putting a cap on the maximum a prospective borrower can access. Age, health status, credit history, and value of collateral are also factors used in the determination of the amount a borrower can access. For instance, a younger borrower will be able to access higher limits than an older borrower.
Tenure
Tenure refers to the period of loan repayments, factors such as Age, Health status, Educational background, type, and value of the collateral also play an important role in the determination of the repayment period of the loan. The tenure for secured loans is always longer than for unsecured loans primarily because collateral is involved. The bank is, therefore, more confident in leaning their depositors’ money with you for longer. Mortgages can be paid over 20 or more years depending on the policy of your banks, the age of the applicant, and the repayment source. The unsecured loan generally has shorter tenure, some short-cycle transactions like LPO (Local Purchase Order) finance and IDF (Invoice Discounting Facility are for as short as 60 days, 90 days, or 180 days depending on the nature of the order. Personal loans can be for a maximum tenure of 60 months in some cases.
Interest Rates
Read my article on interest rate to have clearer understanding of interest rate. Interest rate Rates on secured floats are generally lower than unsecured loans. This is so because the bank faces a higher risk lending to a customer that has not provided any collateral security and thus charge higher to mitigate the risk.
Approval Process
The approval process for an unsecured loan is usually quicker than for a secured loan because there is less paperwork. There is no need to approach government agencies to verify Land and building documents or other collateral that may have been pledged by the borrower, the bureaucratic bottlenecks associated with such verifications and the subsequent delayed approvals are not part of the process of approval for unsecured loans.
Know Before You Borrow
Both secured and unsecured loans can differ a good deal from one bank to the next, so it’s important that you have a clear understanding of how your loan will work, what you’ll have to pay each month and over the life of the loan, information you are providing for the lender matters a great deal here. It will help the bank decides how to structure your loan for easy repayment.. Ask your bank to provide an explanation of all the details plainly. Before you make your borrowing decision, make sure you can afford to pay back your loan in a timely matter without straining your budget.
