Differences Between Secured Loans and Unsecured Loans
Secured Loans Vs Unsecured Loans
When you want to borrow, you have the option of applying for either secured loans or unsecured loans. However, you don’t just choose your option arbitrarily. You need to take some factors into consideration. Some of the factors you may be able to control by yourself, while some factors may subject to situation that applies to you in particular. Before you can decide whether to borrow secured loan or unsecured loans, you should understand what they mean and the differences between the two types of loans
Secured Loans Definition
Secured loans are the types of loans that you will need to pledge assets as collateral before lenders can grant you the loan. The essence of the collateral is to provide security for the lender in case the borrower defaults in payment. We all understand that loan involves risks. There is a risk that the borrower may not be able to pay the interest on the loan. This implies loss of income to the lender. Another risk is that the borrower may be unable to pay back even the principal. This means loss of capital to the lender. With secured loans, these risks are reduced to a greater extent. If the borrower defaults in payment, the lender can simply fall back on the collateral. In the case, the lender will have to sell the collateral and apply the proceeds to recover his money. That is why lenders will like the value of any asset being pledged as collateral to be equal or greater than the loan amount. However, there may be situations where the proceeds from the sale of the asset deposited as collateral may not be sufficient to pay off the entire loan balance. In this case, the borrower will need to find another way of paying the loan balance. Good examples of secured loans are auto loans and mortgage loans.
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What can you use as collateral for secured loans? You can use assets such as car, house, stocks or bond certificates as collateral. In some cases, what you want to use the money you are borrowing can serve as the collateral. Good examples of these are car in the case of car loan and house in the case of mortgage loan. Please note that you will not be able to use one asset as collateral for two different loans. The lender will require that you deposit the deed or title the assets you are pledging as collateral with them. The documents remain with the lender until you have successfully pay off the entire loan both principal and interest.
Unsecured Loans Definition
In contrast to secured loans, unsecured loans do not require that borrowers pledge any asset before the loan can be granted. Instead, the lender will have to rely on the creditworthiness of the individual borrower. If the borrower defaults, the lender may not have any asset to sell in order to recover his money. This makes unsecured loans to be riskier than secured loans. That is why the interest rates on unsecured loans are usually higher than secured loans. This is to compensate lenders for the additional risks they take. Unsecured loans can also be referred to as personal unsecured loans or signature loans. Good examples of unsecured loans are student loans, credit cards and personal line of credit. In most case, unsecured loans will require that you have very good credit score. The lender will usually check your credit rating before granting you unsecured loans. If you have a bad credit, the interest rate that the lender will charge you will be very high. The only way to bring your interest down with unsecured personal loans is for you to have very good credit rating. Before you apply for unsecured personal loans, it is good that you order for your free credit report. This will allow you to review the report for possible errors. If you notice any error in your credit report, you should contact the credit bureau agency immediately in order to investigate the matter and then make necessary correction. A correction of error in your credit report can add few points to your credit rating and this can make a lot of difference on how the lender will rate you.
It is actually good that you don’t make late payment or default paying unsecured loans. What happens if you default in paying back your unsecured loan? The lender will report any late payment or default to the credit agencies. This will appear in your credit report. This will have adverse effects on your credit score and you may find it difficult to get new credit. Besides, this will affect other things such as the ability to get cheap insurance rate, new employment or apartment to rent. Also, the lender may take legal action against you. This may result to the garnishment of your wage. Wage garnishment is a situation where by a portion of your income is withheld every month towards the repayment of your defaulted loans. You will end up paying more as you will need to pay late payment fee, accumulated interest and the collection fee.
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So, you may want to ask, between secured loans and unsecured loans, which is better? Well, both types of loans have their pro and cons. That is why I will like to compare the two loans below. I mean secured loans and unsecured loans.
Secured loans and unsecured loans compared
Collateral: If you have asset that you can pledge as collateral, secured loans may be a good option. However, this is not without risk. The risk is that, if you default in paying back the loan, you may lose the asset that you pledged in the process. A lot of people have lost their homes to foreclosures just because they couldn’t pay back their mortgage loans. Therefore, before you pledge your asset, you should be sure that you will be able to pay back the loan. The best way to prevent default is to ensure you don’t borrow beyond what you will be able to pay back. Even if the lender is willing to grant you more loan, you should know where to place a limit. Some lenders will be willing to give you as much loan as possible if they know that the proceeds from your asset that you pledge as collateral will be enough to pay back the loan. It is you that should be able to discipline yourself. If you don’t have collateral, then unsecured loans will be your option.
Interest rate: The interest rates on secured loans are generally lower than unsecured loans. The interest rates on the two types of loans are the reflections of the risk involved. Because the lender may lose his money in case of unsecured loans, the interest rates attached are generally low. If you are seeking how to reduce interest rate that you will pay, secured loans will help you achieve this.
Amount: If you need a large amount of loan, you may not find lenders that will grant you unsecured loans. Large amount of loan usually requires collateral. For example, if what you want to borrow is just $2,000, you may not need to pledge any asset as collateral. But for somebody who wants to borrow as much as $25,000, your creditworthiness may not be enough to convince the lender to part with such amount of money. Exception to this may be student loans. As a student, you may not need to pledge asset as collateral. Instead, you may need someone to co-sign your student loans for you. The implication is that, if you default in payment, the co-signer of the student loan will be responsible for the repayment of the loan. Only persons that know and trust you very much may be willing to co-sign your unsecured loan. Your parents or close relation may be willing to co-sign your loan for you.
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Duration: While unsecured loans may not last for long period, secured loans do last longer. For example, unsecured loan may just be for three to five years, secured loans such as mortgage loans can last up to thirty years. Therefore, if you need a loan that will span through a very long period, you will need to apply for secured loans. That means you should be ready to provide collateral for such loan.
Credit Rating: When it comes to borrowing, your creditworthiness will go a long way in determining whether you will get the loan you are applying for or not. However, this is more prominent with unsecured personal loans. Your credit rating is the factor that lenders consider most when you apply for unsecured personal loans. Therefore, if you don’t have good credit rating, it may be practically impossible for you to get signature loans. If you succeed in getting it, the interest rate is going to be very high. For people with bad credit, secured loans may be a better option except they have someone with very good rating who will cosign their personal unsecured loans for them. That is why you will mostly come across lenders advertising secured loans for bad credit. You can easily use secured loans to build credit if you make your monthly repayment promptly without default.
Purpose: Secured loans are more specific. If you are borrowing auto loan, it will be expected that you use the money for the purchase of the car. If it is mortgage loan, the lender expect that you use the money for the purchase of your home and not otherwise. But in the case of unsecured loans, you can use the loan for various purposes ranging from debt consolidation to purchase of anything that interest you. People do take unsecured personal loans to finance their wedding, payment of children’s school fees, home improvements and holiday trip. Notwithstanding, it is not good to be reckless about how you spend your unsecured personal loans. For example, spending unsecured personal loan on a very expensive vacation trip may not be a good idea. You may not know the effects this can have on your credit immediately. But by the time it comes to repayment, you may find it difficult to repay the loan. This will jeopardise your credit in the future. The lender may even institute a legal action against you. This may lead to wage garnishment, meaning that a certain portion of your wage will be deducted every month until you are able to repay the entire loan. This can impact your cash flow thereby making it impossible for you to spend money on other pleasurable things.
Hidden Benefits of Unsecured Loans
In spite the fact that the interest rates on unsecured loans are usually high, some people will still prefer it for certain salient reasons. Few of such reasons are discussed below:
- The processing is fast: If you need money very urgently, unsecured personal loan can come to your rescue. It does not require much documentation as in the case of secured loans. When you apply for a secured loan, the lender will like to assess the value of the asset you are pledging as collateral so as to be sure that it will be sufficient to pay off the loan in case of default. Assessment of the asset may take some time. But in the case of unsecured personal loan, the processing is faster as there is no need for such assessment.
- The risk is low: When a person pledges as security for a secured loan, there is possibility that he may lose the asset if he is unable to pay off the loan. But for signature loans, the lender only rely on your creditworthiness with the promise that you will pay back the loan. Therefore, if you default, you can still be at peace knowing fully well that your assets are intact. The burden of inability to pay debt is enough on his own not to talk about when one lost his asset such as home in addition. This can cause emotional pain. But with signature loan, you can concentrate on how you can pay back the loan only.
- Short term loan: Unsecured personal loans are usually for a short term. This mean that the debt is not spread over a long period. This gives you opportunity to quickly pay off the loan and move ahead. It is easier to get new loan when you don’t have much loans that you are servicing.
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Requirements for Unsecured Personal Loans
This article will not be complete without mentioning the requirements that lenders may expect you to meet before they can approve your application for the loan.
- Age: You will have to attain the minimum age of 18 years.
- Citizenship: If you want to take a loan in US for instance, you must be a US citizen or at least a legal long term resident.
- Employment: You must be gainfully employed in any approved company. You may be required to have been in the employment for certain number of months, say three months minimum. People with consistent employment and a longer track of income stand a better chance of having their application approved.
- Proof of your income: The lender may request for your past pay slips as a proof of your income. Your income should be able to justify the amount of loan you want to borrow. If your income is too low, it is either that your application is rejected or you will be approved for an amount that you will be able to pay back considering the level of your income. If you have other sources of income such as dividend income, stock sale and inheritance, this will increase your chance of having your loan approved. However, you will need to prove this with necessary documentation.
- Proof of residence: Your recent utility bills will suffice for this.
- Means of Identification: Lenders prefer government issued identity card such as valid passport or driver’s license.
- Credit Score: Your credit score is what lenders use to gauge your creditworthiness. If you have a good track of repaying your debt, this will be revealed in your credit history. Your credit history is one of the main criteria used in calculating your credit score.If you have the history of late payment or default, it may be difficult for you to get personal unsecured loan. On the other hand, you will have limited chance of comparing rates as few lenders will be willing to grant unsecured loans to people with bad credit.
- Application: You will need to complete the loan application form stating the amount you are applying for. Also, you must agree to all the terms and conditions of the loan.
These are just general requirements, each bank or lender may have their own specific additional requirement. Nevertheless, the next time you want to shop for loans, I believe that you now know whether secured loans or unsecured loans will be suitable for you. There are many companies that offer online unsecured loans these days. You can take advantage of this to ensure that you get your loan at a good rate.