Secured vs. unsecured loans

Getting a loan from a bank or financial institution can be just what you need to fulfill your dream of owning a car, purchasing a house, or even starting your business. But whether you should opt for a secured loan or get an unsecured loan can be a tough decision.

This article breaks down everything you need to know about secured and unsecured loans.

The primary differentiator between a secured loan and an unsecured loan is whether the loan is backed by security.

Here’s a detailed overview of each type of loan to help you decide between secured loans vs unsecured loans.

When you apply for a secured loan, you need to provide the lender with security. This can be an asset that offers some value such as your property, accounts, receivables, or even your business inventory. For certain secured loans such as car loans, the asset you want to purchase using the loan amount itself becomes the collateral.

In the event your financial situation is such that you are unable to carry out timely loan repayments, the lender can encash the security to satisfy the outstanding balance.

Usually, borrowers enjoy a lower interest rate for secured loans as the collateral minimises the risk involved for lenders. When comparing secured loans vs unsecured loans, here are a few things to keep in mind:

• The type of collateral lender is looking for
• The interest rate for the loan
• Whether the interest rate is variable or fixed
• Whether the lender will charge a prepayment fee if you repay ahead of the agreed schedule
• Is there a maximum amount of loan you can borrow

Secured loans can be availed for several end uses. The approval process for getting a secured loan sanctioned is usually longer when compared to an unsecured loan. Moreover, lenders may also undertake value assessment and need you to furnish additional documentation.

You don’t have to furnish any physical asset to borrow an unsecured loan. Such loans are sanctioned based on your business cash flow if you are borrowing it for your business or your credit score if you are borrowing it for yourself.

Compared to secured loans, such loans are usually provided at a higher interest rate since the lender has no collateral to fall back on. That’s why the creditworthiness of the borrower is such an important factor. The absence of collateral also makes unsecured loans a popular choice for customers as lenders cannot exercise any rights over their property.

When it comes to secured lending, the security for a loan can be any valuable asset, such as your car, house, or valuable jewelry. The asset reduces the lender’s risk of lending if you do not repay the loan. They can seize the secured asset and sell it off to recover a part or the entire outstanding.

The interest rate on secured personal loan in Australia is usually lower compared to unsecured loans as lenders have the benefit of the secured asset. The loan proceeds of a secured loan can be utilised for any purpose. For instance, you can get a loan with a car as collateral and use the funds to renovate your home. The loan proceeds can also be used for purchasing the collateral. For example, in the case of a car loan, the car is the asset securing the loan you receive the finance the purchase of the car.

Note that there is a difference between secured credit vs loan. Secured credit lines, such as secured credit cards require a cash security deposit which acts as collateral. The card issuer uses the deposit in case you default on your card payments. The deposit also acts as your credit limit.

As the name suggests, unsecured loans are the opposite of secured loans.

In the case of unsecured finance, furnishing any physical asset isn’t necessary. If you are borrowing an unsecured personal loan for yourself, the loan is sanctioned based on your credit score, whereas if you are borrowing for your business, the cash flow is considered.

As a result, such loans carry a higher interest rate since there is no collateral to counter the lending risk. Yet, it remains a popular option as borrowers don’t risk losing their rights over an asset. The lender may impose some restrictions on the end use of such loans. Typically, most borrowers opt for unsecured loans for carrying out debt consolidation, paying for a wedding or vacation, or undertaking home improvement projects.

A secured loan can be availed for different end uses.

Based on the utilisation of the loan amount, it can be broadly classified into:

Secured business loans

This refers to loans you can avail of to meet a number of funding needs of your business, such as purchasing new equipment or machinery, expanding your business, purchasing new office space, or purchasing raw materials. The collateral for such loans may vary -- it can be real property, receivables, government securities, or even fixed deposits and savings accounts.

Depending on the loan amount, a lender may even insist on personal guarantees from the business owner. Your eligibility for the different business loans will depend on your business credit score.

Secured personal loans

These are loans you can avail of for your personal use. The asset you intend to purchase using the loan amount often becomes the collateral for such secured personal loans.

A secured personal loan can be of different types, such as:

Car loan

A car loan or an auto loan involves borrowing a sum of money to fund the purchase of a vehicle. The loan is secured with the vehicle itself. So in case the financial situation of the borrower deteriorates, and there is a payment default, the lender can seize the vehicle and sell it to meet the outstanding debt.

Interest rates of car loans are usually decided using simple interest. In other words, the borrower repays the loan amount along with a flat percentage of the borrowed amount. Secured car loans are also amortised which means the early payments of the loan factor in interest rates.

Bear in mind that while some banks may also extend an unsecured car loan, significantly higher interest rates of such loans might make it commercially unviable to borrow. Therefore, it may be better to opt for secured car loans.

Mortgage loan

A mortgage loan is a type of secured loan that a borrower can avail by mortgaging an immovable asset with the lender. These loans are available to buy homes or any other real estate. In most cases, the property to be purchased itself becomes the security for the loan.

The interest rates vary depending on the type of property and the ability of the borrower to repay the loan.

Savings-secured loans

Instead of a physical asset, these loans are secured by the amounts you hold in a savings account or through certificates of deposit. They are popular due to their low-interest rates and provide an ability to the borrower to borrow against amounts already available instead of spending it in a single shot. Moreover, you can continue to earn interest on the savings while you repay the loan.

These secured loans allow you to borrow the same amount that you have in your savings account or savings certificate. For example, if you have $6000 in your savings account, you are eligible to borrow a $6000 loan.

Life insurance loans

This is a type of secured personal loan that allows you to borrow against your life insurance policy. The value of your insurance policy acts as collateral. While you have the option to repay the loan in installments during your lifetime, the outstanding loan amount can be deducted from the insurance amount due to your beneficiaries once you pass away.

A bank or a financial institution holding a valid Australian credit license can disburse all types of secured loans.

Similar to secured loans, there are various types of unsecured loans based on their utilisation, such as:

Unsecured personal loan

Unsecured personal loans can be borrowed to fund the personal needs of an individual. There are personal loans available to meet wedding expenses or take a vacation or undertake home renovations.

Unsecured business loan

Unsecured business loans are availed for funding the needs of a business without pledging any collateral. The loans are disbursed by banks or financial institutions after evaluating the cash flow of the borrower.

Such unsecured loans can be further classified into the following categories based on their tenure and repayment structure. These include:

Revolving loans

One of the most common unsecured loans is a revolving credit facility. This allows borrowers to borrow an amount, utilise it, repay it and start withdrawals again. There is a credit limit assigned for such unsecured loans making it easy for the borrower to borrow as many times as needed provided the limit is not breached. The flexibility of borrowing is one of the key reasons why such a loan facility is attractive for borrowers.

These types of unsecured loans are perfect to meet the working capital requirements of a business. The borrower doesn’t have to repay following a strict repayment schedule and the interest rates are also variable.

Term loans

Unsecured loans with a fixed rate of interest and tenure are known as term loans. Borrowers can either opt for short-term loans to meet any immediate funding needs of their business or go for intermediate or long-term loans for lump-sum funding.

Consolidation loans

Sometimes a borrower may find it challenging to repay multiple loans. In such cases, they can opt for a consolidation loan to repay the outstanding amounts of all the accumulated loans.

Banks or financial institutions with a valid Australian credit license can extend unsecured loans.

In case you have bad credit score, you can also consider applying for bad credit debt consolidation loans.

Secured loan or unsecured loan -- how do you know which is the right one for you?

Comparing the differences between unsecured vs secured loans can help you decide. Here are some pointers you should keep in mind.

Collateral

The primary difference between secured loan vs unsecured ones is the presence of security.

In the case of unsecured loans, you don’t have to provide any assets to secure the borrowing. Your creditworthiness helps the lender decide whether to lend to you, along with other factors such as your income and other outstanding debt obligations.

On the other hand, if you want a secured loan, you must have collateral to offer. The collateral should be free of encumbrances or other security interests so that your lender can seize it and realize the outstanding debt if you fail to repay it.

Rate of interest

Another critical difference between secured vs unsecured loans is the interest charged. When compared to unsecured loans, the interest rate of secured ones is much lower. This is because the risk of lending is lesser in the case of a secured loan, as the lender can sell the collateral to recover the dues.

Repayment period

When it comes to comparing the repayment period of secured and unsecured loan, it tends to be longer for the former as the interest rate is lower.

Loan amount

If you compare the amount of loan secured vs unsecured you can borrow, lenders usually offer higher loan amounts when you pledge an asset as security.

Lender’s risk

Between loan secured vs unsecured, the lending risk of banks disbursing unsecured loans is higher since there is no security to square off the risk. If the borrower defaults, the lender has no remedy other than initiating recovery proceedings.

Borrowing limits

Between secured vs unsecured loan, the borrowing limit of unsecured loans is on the lower side. This is because there is no collateral to reduce the risk of lending.

Between secured vs unsecured loan, you must choose one that suits your needs.

For example, if you check your credit report and find that you have an excellent score and your debt-to-income ratio is less than 50 percent, an unsecured loan is a better option. Your credit score may help you negotiate favorable lending terms, including a competitive interest rate. You won’t have to run the risk of losing your asset in the event of not repaying as per the agreed terms.

If your credit score is not good enough to get unsecured financing, go for a secured one out of secured vs unsecured loans. However, consider whether you are prepared to take the risk of borrowing by providing valuable assets -- for instance, defaulting on a secured home loan means losing your residence in the event of loan defaults. If you are sure that you can meet repayment obligations and want to borrow at a lower interest rate without offering any collateral, a secured loan is the way to go.

It is a popular misconception that lenders do not want to extend any financing to borrowers who don’t have a perfect credit score. In reality, there are some lenders in the market who offer specialised products to bad credit borrowers, and secured loans are one of them.

In fact, many borrowers prefer secured loans for bad credit as they are easier to qualify for when they don’t have an excellent credit score. So if you are struggling to choose between secured vs unsecured car loan and your credit score is not good, opt for a secured one . You can also use the loan as a credit-building loan and boost your credit profile as long as you pay the loan instalments on time.

To sum up, secured and unsecured loans are the two major financing methods available in the market.

Since unsecured business or personal loans are not backed by any security, your creditworthiness is crucial to obtain a loan on favourable terms. The best way to determine your creditworthiness is by looking at your credit score. With ClearScore, you can access a free credit report and get credit score know what to expect when you approach a lender.