There are times when the money that you may have in your possession isn’t quite enough for a major purchase (such as a car, a boat or a house) and you may need to obtain a loan. Deciding which type of loan is the right type for your situation needs to take into consideration your assets, cash flow and overall goals.
In this case, you may be trying to decide between a secured and an unsecured loan. There’s a key difference between the two types, and it is primarily to do with whether or not the lender requires ‘security’. This generally comes in the form of collateral assets to incentivise the payback of the loan.
A secured loan requires security (using assets at collateral, such as property, vehicles or inventory). If the loan cannot be met, the lender may use the assets as collateral to clear any outstanding balance, interest or fees.
Essentially, the lender can take possession of the asset and sell it to cover the cost of the loan. However, this also means that the lender can offer a lower interest rate for the loan.
You are more likely to be approved for a secured loan if you can present a collateral/security for the loan that has a value that can match the amount a borrower is intending to borrow. This does also mean that your collateral’s fair value (the asset’s price determined by buyer and seller) needs to be bigger than your loan amount. Lenders will also likely set a higher borrowing limit for secured loans in comparison to unsecured loans, and will not require a guarantor on the loan (as your collateral is the backer in this instance).
Secured loans allow for you to borrow against your assets, but also may involve a longer approval process and period due to the consideration of the assets provided as security. They may require value assessments, additional proof and the documentation of those assets.
Some of the assets that can be used as collateral for secured loans include;
- Bank accounts
- Stocks, mutual funds or bond investments
- Insurance policies, including life insurance.
- High-end collectibles and other valuables,
An unsecured loan is not backed up by collateral, which means that an unsecured loan has a greater risk for the lender. This is because the borrower does not provide an asset of value to offset their losses in case of default.
Instead, to determine whether you will be able to pay back the loan, lenders will generally judge you on character, capacity, capital and conditions.
- Character refers to a loan applicant’s business acumen, reputation, credit history and track record to repay debt. It includes your credit score, employment history and references.
- Capacity involves the lender’s assessment of the borrower’s ability to repay the debt.
- Capital means that lenders look into the borrower’s overall financial position (including assets and liabilities, net worth and liquidity).
- Conditions include the terms of the loan, outlining the length of repayment, interest rates, frequency of repayment etc.
In the instances of unsecured loans, you do not require collateral to secure a loan – as long as you have a good credit history and credit score, that can be enough to secure the loan. For those who are looking for a short-term and easy-to-access loan, unsecured loans are ideal.
You do need to consider however that an unsecured loan generally comes at a higher interest rate (the price of their convenience). There are also penalties that may be in place for borrowers who violate the terms and conditions of the loan. Your credit history may be adversely affected if you fail to repay the loan amount though, and you will also require a fairly high score/good history for it to be considered for approval.
When it comes to what is better suited to you, you need to examine your objectives, financial situation and your personal circumstances. What’s most important, after deciding what’s right for your specific situation is having a plan in place to pay it back. You can speak with us for help in developing that plan.