If you have ever considered taking out a loan, you know you would have been subjected to lots of jargon and financial terminology that does not seem very clear. Many people feel overwhelmed or intimidated by this unfamiliar language.
At the same time, they feel a little embarrassed by asking someone to explain it to them. You might have been in this position before, feeling unsure of what lenders are talking about. Two words you might have heard are secured and unsecured. What do they mean in the context of a loan?
Defining Secured and Unsecured Loans
When explaining the difference between secured and unsecured loans, the primary issue to keep in mind is collateral. Many people apply for online unsecured loans because they do not have to offer any assets up as security. When you enter a secured loan, the lender requires something as security to reclaim if repayments are not made.
Whether you take a secured or unsecured loan depends on the transaction’s nature. Lenders are reluctant to hand borrowers large sums of money in unsecured loans. For example, a mortgage loan is secured by the house for which it is applied. This means that if you do not make repayments, a financial institution can foreclose on your mortgage and take the property away.
Short-term loans for smaller amounts tend to be unsecured, and you will not risk losing any assets if there is a problem with repayments. This includes payday loans and personal loans.
When determining what type of loan you need in your current situation, financial literacy is vital. You should understand the differences between various loan products and each one’s advantages and disadvantages. This knowledge helps you make the correct choice that best suits your needs. If you are unsure of any loan terms and conditions, find out more and get all your questions answered before signing any documents.
Characteristics of Secured Loans
As mentioned, secured loans tend to be for large amounts, such as that required to purchase a home. They are also referred to as long-term loans, as the repayment period can last up to 20-25 years. Other names you might have heard before are home equity or homeowner loans, second mortgages, and first charge mortgages.
While the risk of losing an asset for non-payment of a secured loan is a disadvantage, there are many advantages to taking out such loans. First, the interest rate on a secured loan is lower than an unsecured one. Second, you have longer to repay your loan. Third, you can apply for another loan against your current mortgage. Homeowners do this to spend on renovations or to raise a deposit for a second property.
Characteristics of Unsecured Loans
Borrowers view unsecured loans as more straightforward than their secured counterparts. There is less risk because you cannot have assets seized if you do not pay installments. The loan amount is typically smaller, and the purpose differs from that of a secured loan. You can use a unsecured loan to buy a car, make other purchases, finance home improvement, or consolidate outstanding debts.
However, a failure to pay can land you in plenty of trouble. First, you incur additional interest on the outstanding payment, which compounds daily. Unpaid debt reflects poorly on your credit rating, which can affect any future applications for loans and other financial products.
A dent in your credit score can be challenging to rehabilitate and should be avoided if possible. Worse still, a lender can sue you for the outstanding amount in court. Your financial behavior could become a matter of public record.
Interest Rates on Secured and Unsecured Loans
Lenders offer different interest rates, so it is always advisable to shop around to find one that provides a competitive rate. When taking out a secured loan, you can choose between a variable-rate or fixed-rate repayment schedule.
A variable-rate loan is linked to current interest rates prescribed by a central bank. The installment is calculated according to the prevailing interest rate. Should interest rates go up, so will repayments.
If they are reduced, the total installment decreases. Many lenders see this as a risky proposition because an interest rate hike of as little as 0.5% could strain their budget. However, if you think there is a reasonable chance that interest rates could decline considerably, you should consider a variable-rate loan.
There is no change to the monthly repayment amount if you select a fixed-rate loan. Regardless of interest rate changes, the installment remains constant. This is a wise course of action if experts predict that interest rates will likely go up over the coming years.
The choice between a fixed-rate or variable-rate loan is a personal one. If you are risk-averse, a fixed-rate loan is your ideal option. Those more confident about their knowledge of potential interest rate changes might opt for a variable-rate loan.