Loans play a crucial role in filling the shortage of funds when you want to buy a house, a car or for any type of immediate personal need. You take out a loan to finance your studies or a new business. Therefore, it is important to understand the two types of loans – secured and unsecured loans and the differences between the two. While in secured loans, collateral is pledged, unsecured loans are those that are given on the basis of the creditworthiness of the borrower.
The two types of loans have different purposes and are different in terms of duration, interest, eligibility, etc. Some of the secured loan products are home loans, home equity loans, fixed deposit loans, gold jewelry loans, and auto loans. Personal loans and credit cards are types of unsecured loans.
So how will you decide which loan is right for your needs? It will depend on your needs in terms of duration, purpose, interest and amount of the loan.
Points to remember when taking secured or unsecured loans
As stated above, you can opt for an unsecured loan if your CIBIL score is sufficient. This means that you have to keep your appetite low for unsecured loans by not applying for too many of them. Although unsecured loans are readily available, it is best to exercise restraint. Paying off an unsecured loan in a disciplined manner would help you improve your credit score. It’s best to review your loan balance from time to time.
It is also important to note that while taking an unsecured loan, do not pledge collateral, which has a higher value than what the bank needs. You can opt to pledge two or more smaller assets, which match the value of your loan.
You can go for a secured loan as long as you have enough cash, collateral and asset backups as it would cost you a lower interest rate. For example, you can take out a loan against your fixed deposit at 1% to 2% spread over the FD interest rate.
Banks usually look for collateral for long term loans. For short-term loans, which are between six months and two years, banks assess your repayment capacity based on your income and offer a personal loan without asking for collateral. Personal loans have a relatively higher interest rate and prepayment penalties may also be imposed.
Bank account holders who have good transaction history and CIBIL score could easily get unsecured loan from banks.
Let’s take a look at some of the features of secured and unsecured loans
Interest rate: The interest rate is low because the collateral is pledged and the risk is low
Availablity: Readily available
Mandate: Short to long term
Amount of the loan : The loan amount is relatively higher and is determined based on the availability of collateral
Processing time: verification steps extend the duration
Chances of rejection: Low, depending on the loan requirement and the availability of collateral to be pledged against the loan.
Interest rate: High interest rate. Interest charged based on the length and amount of the loan, etc.
Availablity: Good credit score and good banking relationship required
Mandate: Available in the short and medium term
Amount of the loan : The loan amount offered depends on the income and credit rating of the borrower. The ceiling is relatively lower.
Processing time : The loan disbursement is faster due to less paperwork.
Chances of rejection: High, depending on credit rating and income level.
(The author is CEO, BankBazaar.com)