Borrowing from a bank is not a bad idea but it has to be done wisely as borrowing can help reach your financial goals or destroy your life if being done reckless and excessively. It is crucial to think long and hard before making the decision to take a bank loan.
There are different loan options offered by banks and if you are considering taking out a personal loan, it’s important to understand the different types of loans that are available to you.
This week I will talk about the difference between two common types of personal loans; unsecured personal loans and secured personal loans.
Anytime you borrow from a bank, a bank may allow you to borrow the money with only your promise to pay it back or the bank may require you to use an asset as a security for the loan. Any loan that is backed with security is called a secured loan while an unsecured loan is not tied to any kind of asset.
Let me start off with secured loans. Common types of secured loans are mortgages, car loans, and equity release loans in which items financed become the collateral for the financing. The bank maintains an equity (financial interest) in that collateral until the loan is paid in full.
This means that you agree that the bank can take the collateral if you don’t repay the loan as agreed.
Therefore, if the borrower defaults on the payments, the bank can seize the collateral and sell it to recoup the funds it had loaned out to the borrower. If the collateral doesn’t sell for enough money to completely cover the loan, you will be responsible for paying the remaining amount of the loan.
With the risk of having your collateral seized if the loan is not paid, you might wonder why anyone would choose a secured loan.
The reasons why people are choosing secured loans include: their credit history does not allow them to get approved for an unsecured loan, secured loans allow a borrower to get approved for higher loan limits (amount) based on your affordability, longer repayment period, and they have lower interest rates. From a bank’s view, the risk of default on secured loan tends to be relatively low since the borrower has so much to lose (i.e. the collateral) by neglecting his/her financial obligation.
Meanwhile, an unsecured loan is not tied to any of asset so the bank has no collateral to fall back on incase a borrower defaults. Common types of unsecured personal loans are salary loans, personal lines of credit, and student loans.
You typically need to have a good credit history and solid and constant income (salary) to be approved for an unsecured personal loan.
The main reason people choose unsecured loan is because they involve lesser paper work and its approval process is shorter.
Banks take a bigger risk by giving out loans with no collateral to recover in case of a default, which is why the interest rates for unsecured loans are considerably higher.
In addition, loan amounts may be smaller since the bank doesn’t have any collateral to seize if you default on payments. Since there is no security required, the bank will decide to give an unsecured personal loan using the five C’s of credit to assess a borrower’s creditworthiness; character, capacity, capital, collateral, and conditions.
Furthermore, credit-to income ratio is a very important deciding factor used by banks for unsecured personal loans to ensure the risk of default is as minimal as possible.
To summarize, there are two main types of personal loans; secured and unsecured personal loans. Any loan that is backed with security is called a secured loan while an unsecured loan is not tied to any asset. Secured loans usually have higher amounts, longer repayment period, and lower interest rate. While unsecured personal loans have shorter repayment period, lower loan limit, and higher interest rate.
Mr Mkwawa is a seasoned banker