Most of use need some form of financial assistance at some point in our lives. This could be for purchasing a car, or a home or in the form of a credit card. Taking a loan has become commonplace, as the cost of living rises and the divide between personal income and the price of various essential commodities widen. Loans today have shifted from a need based objective, and are now an integral part of most people’s lives. So, as a borrower, what are the kinds to things should you be mulling over before you decide to take a loan? Read on to find out.
With this growing need for credit, it is vital that you make the most out of your personal finances by inculcating smart borrowing techniques. To become a smart borrower, its first important to understand the various types of loans available to you, and see how each one will impact you especially when it’s time to repay the loan. We have objectively looked at each loan type so that you get a better understanding on which loan is most suitable to you. This article aims to break down the various loan types in a more simplified manner to help you make the best decision.
Secured and Unsecured Loans
Any loan that is borrowed from a lending institute, be it a bank or a credit union is likely to fall under these two categories – Secured Loan or Unsecured Loan. A lender who loans you a certain amount of money, does so, with the promise that you will eventually pay back the amount plus the interest accrued. In often times, the lender, in order to reduce the risk of not receiving the payment in full, may ask you to secure the loan with one of your assets. This factors alone becomes the primary distinction between a secured and unsecured loan.
A secured loan is one that is protects the risks of borrowing using some form of capital. For example, a mortgage can be secured by the value of the house itself or a car or additional property that is used against the loan to cushion the risk of the lender. This capital is known as collateral. The lender has legal right to hold the collateral, till the borrowers pays the loan off; this includes interests and all other charges. For example, for a mortgage, the lender will hold the deed or the title, or in the case of a car the lender can keep the original registration certificates . Secured loans can use other forms of collateral like stocks and bonds , personal property or others.
NOTE: It is important to keep in mind that collateral can be repossessed, if the lender for any reason is unable to pay off the loan as per the agreement. When the borrower signs the dotted line, he/she gives the lender complete authority to repossess if the they default on the loan. If the total value of the collateral in insufficient to pay off the entire loan the borrower in some cases might be liable to pay the difference.
One huge selling point for a secured load is that it is relatively easier to procure. Especially for individuals who have a poor credit history or are in the process of building their credit. The reason for this is that a lender will generally not hesitate to give a loan when there is less risk involved. The lender knows that an individual who puts up his/her property as security for repayment of the loan, is more likely to repay the loan. Additionally, secured loans also offer higher borrowing limits, so a borrower will find it easier to acquire larger sums of money in lesser time.
In addition, secured loans tend to offer a better interest rate and longer repayment terms. This is ideal for individuals looking for larger sums of money at a lower interest rate as they can spread out their monthly payments in a more even manner. All this translates to better money management decisions and easier credit options and more security for the lender.
Some examples of secured loans:
- Auto loan for new vehicle
- Auto loan for used vehicle
- Home Equity Line of Credit
- Boat Loan
- Recreational Vehicle Loan
Unsecured loans are the exact opposite, when it comes to using collateral to secure the loan. Because of this lack of collateral, lenders will generally tend to look at this loan type with more risk. This is because in the event that a borrower is unable to payback the loan the lender will not be able to seize capital as payment for the loan. This is primarily why the interest rates on an unsecured loan are generally much higher.
A lender basis his decision to give a loan on the creditworthiness of the borrower. This involves having a good credit history and a strong monthly income. This is what is generally known in the finance world as the 5 C’s of creditworthiness - Character, Capacity, Capital, Collateral, and Conditions. The lender when giving an unsecured loan will look at the borrower’s portfolio and will pay close attention to these 5 points. In order to substantiate his creditworthiness, the borrower may be asked for considerable documentation that proves his income, financial stability and ability to repay the loan. This includes, bank statement/s, salary slips or other documents that state his income or other bonuses received.
Some examples of Unsecured loans:
Besides the borrower’s ability to repay the loan, some external economic factors may also play into the lenders final decision; like unfavourable market forecast that may directly impact the borrower’s income.
NOTE: If a borrower is denied an unsecured loan, he/she is can still be eligible for a secured loan. The only criteria being that sufficient collateral should be put down as security, which is equivalent to the amount of the loan applied for.
Credit Reporting Authority
Non-payment of both type of loans can affect the credit ratings of the borrower. The lender will generally report to the credit bureau which will show up on the credit report and hamper any future loans that you may want to take. However, with secured loans, in addition to the bad credit report a borrower will have his/her collateral repossessed or foreclosed, which will also show up negatively on the credit report.
Both Secured and Unsecured loans have their advantages and disadvantages and can differ from one lender to another. Its important to understand the loan type and the amount you will be liable to pay over the loan term. Before you jump to your loan decision, make sure you have enough money to repay the loan in its entirety. Its quite possible that there may be better options in the horizon so its also a good idea to look around.