Secured vs. Unsecured Loan: What is the Difference?

There are two broad categories of loans offered by banks and financial Institutions; secured loans and unsecured loans. Understanding the difference between the two is an important step towards achieving financial literacy, which in turn can have a long-term effect on your financial health.

A secured loan requires borrowers to offer a collateral or security against which the loan is provided, while an unsecured loan does not. This difference affects your interest rate, borrowing limit and the repayment terms.

There are pros and cons to choosing a secured vs an unsecured loan, which is why we have highlighted the differences.

Secured Loan

Secured loans are protected by an asset. The item purchased, such as a home or a car, can be used as a collateral. The lender will hold the original Sales Deed or title documents until the loan is paid in full, in case of a Home Loan. Other items can also be used as a collateral, such as stocks, bonds, etc. Secured loans are the most common way to borrow large amounts of money. A lender is only going to loan a large sum, with the promise that it will be repaid. Putting your home on the line is a way to make sure you will do all you can to repay the loan.

Secured loans are not just for new purchases. Secured loans can also be Home Equity Loans or Loan Against Property. The loan can also be in the form of a Line of Credit or an Overdraft. These are based on the current value of your home, minus the amount still owed as loan, if any. These loans are offered using your home as a collateral.

The risk is, if you can’t repay a secured loan, the lender can sell your collateral to pay off the loan.

Features of a Secured Loan:

Lower rates
Higher borrowing limits
Longer repayment terms
Higher processing time, as the property also needs to be evaluated.

Examples of a Secured Loan:

Mortgage – A mortgage is a Home Loan acquired for buying a home. Your monthly mortgage payments will consist of the principal and interest, plus taxes and Home Insurance
Home Equity or a Loan Against Property – A Home Equity Loan allows you to borrow money using your home’s equity or value as collateral
Auto Loan – An Auto Loan is an auto financing option you can obtain through the dealer, a bank or a credit union
Business Loan – A Business Loan may also be secured against stocks or property or both.

Unsecured Loan

Unsecured loans are not backed by any security and include loans like Credit Cards, Student Loans or Personal Loans. Lenders take more risk in this type of funding because there is no asset to recover, in case of a default. This is why the interest rates are higher. If you’re turned down for an unsecured credit, you may still be able to obtain secured loans, but you must have something of value that can be used as a collateral.

An unsecured lender believes that you can repay the loan because of your financial resources. You will be judged based on:

Character – can include credit score, employment history and references

Capacity – income and current debt

Capital – money in your Savings or Investment Accounts

Conditions – the terms of the loan.

These are yardsticks used to assess a borrower’s ability to repay the debt and can include the borrower’s situation as well as general economic factors.

Examples of an Unsecured Loan:

Credit Cards – There are different types of Credit Cards, but general Credit Cards bill only once a month and charge interest if you do not pay the balance in full
Personal Loans – These loans can be used for many purposes and can vary from one range to another
Personal lines of credit – Similar to a Credit Card, a personal Line of Credit has an approved limit that you can use, as needed. You can use this Line of Credit for almost anything and you are only charged interest on the amount you spend
Student Loans – Student loans or Education Loan are used to pay for college education.

Features of an Unsecured Loan:

Higher rates than secured loans
Lower borrowing limit since there is no security, in case of a default
Short repayment terms, usually ranging between 5 - 7 years
Faster processing, as compared to a secured loan.

In conclusion, whenever you have a funding requirement, you should ask your bank/ financial institution for both secured and unsecured loan options and evaluate the terms. If you do own a property, which can be offered as a collateral, a secured loan may turn out to be a lot cheaper and also keep your monthly outgo comfortable. You need to of course consider the time within which you need the loan, as a secured loans will typically take longer for a bank/financial institutionto process, as compared to an unsecured loan.