When seeking financial options to renovate your home, or when your children opt for higher education abroad or for a wedding in the family, this involved a lot of research on banks, interest rates and tenor etc.
In the process, did you ever check if you should be taking a secured or an unsecured loan? The answer most probably is a no. A lot of people do not evaluate what will be better for them.
Both are equally alluring and have their own advantages and disadvantages. Depending on your financial situation, you can choose which works better for you.
The primary difference between secured and unsecured debt is the presence or absence of collateral—something used as security against non-repayment of the loan.
What is a secured loan?
Secured loan is a loan backed by an asset (for instance, a car or property) you own, in order to decrease the risk assumed by the bank. The asset will be taken over by the bank if you fail to make the necessary repayments.
A secured loan can be a car loan taken to buy a car that you always wanted or a home loan taken to buy a flat or house. You can also take it to refurbish your home too.
What is an unsecured loan?
Unsecured loan is given on the basis of your income and expense behaviour and does not require any collateral. It offers the flexibility to choose the repayment tenure between one and five years and the best loan rates are generally given for borrowers looking to make repayments over three and five years.
An unsecured loan can be a personal loan taken for a vacation abroad, a wedding in the family, a business requirement, or for any other need for which you do not have ready liquidity.
A credit card loan which is the most flexible form of short-term borrowings with easy repayment options. Also, a bank overdraft which you can use to avail unsecured finance from your bank for your business.
Key questions to help you decide
Here are the key questions you should ask yourself when choosing the kind of loan you opt for. It should be decided on factors like:
• Which type of loan has a lower rate of interest?
• Do you have any asset to mortgage?
• What is your repayment capability?
• What is the end use of the finance you need? Is it commercial or personal?
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So, secured or unsecured?
A secured loan should be preferred when the interest rates are lower and you get extended repayment options, or if you have greater financial flexibility and more savings options.
Also if you get to choose between a fixed or variable rate (when it comes to a home loan) and decide to pay nothing for the initial term of the loan, then go ahead and opt for a secured loan. And, you should go ahead with an unsecured loan if you need immediate financial assistance with minimal paperwork and if the loan amount is relatively small. And understandably, if you don’t have an asset to mortgage.
With a secured loan, the lender can take possession of the collateral if you don't repay the loan as you have agreed. As an unsecured loan is not protected by any collateral, if you default on the loan, the lender can't automatically take your property.
A secured loan will tend to also have lower interest rates. That means a secured loan, if you can qualify for one, is usually a smarter money management decision vs. an unsecured loan. And a secured loan will tend to offer higher borrowing limits, enabling you to gain access to more money.
What happens if you default?
Whenever you fail to repay a debt, it affects your credit. While unsecured loans have no collateral for the lender to claim if you don't pay, they're not without recourse if you default on the loan.
Lenders can take legal action against you to recoup some or all of the debt. Some lenders could also file lawsuits to recoup monies owed, and this could result in a civil judgment that would negatively impact your credit.
Additionally late payments that are reported impact your credit negatively and future potential lenders will likely see that as a red flag before extending you credit.
Any kind of loan default negatively affects credit scores. Civil judgments also show on credit reports for seven years from the date the account first went delinquent or the date of the ruling against you.
Conclusion or key takeaways?
Whether a secured or unsecured loan is right for you depends on several factors, including how much you need to borrow and your credit score.
Secured loans can allow you to borrow larger amounts of money at lower rates, since the lender can be more confident they won't lose money even if you default. However, you do put your property at risk if you fail to pay.
Unsecured loans don't put property at risk, but they can be more difficult to get and can have higher interest rates and typically, shorter terms.
Before you make any decision about how to use credit, it can be helpful to check your credit report and scores. Knowing your credit score and what's on your credit report can help you make more informed borrowing decisions.