Businesses opt for debt funding in the form of loans when their internally generated funds are not sufficient or when they do not wish to dilute their equity through issue of shares. Individuals may also opt for loans to meet their personal or professional needs such as buying a car or a house or setting up of their business. These loans are generally repaid in installments which have both a principal and an interest component.
This article looks at meaning of and differences between two types of loans based on the attached security – secured loan and unsecured loan.
Definitions and explanations
A secured loan is a loan which has a charge on one or more assets of the borrower to serve as a guarantee for repayment. Such loans have a security attached to it to safeguard the lender in case of non-repayment by the borrower. In case the borrower is unable to pay off the loan within the set time frame, the lender has the automatic right to take possession of the asset offered as security and liquidate it to recover his funds.
The security attached to such loans can generally take two forms:
1. Fixed charge loans:
such loans are directly backed up by one or more specific and identifiable assets. In case of default by the borrower these specific assets are liquidated and money is recovered by the lender. For example, a loan obtained by an individual to purchase a vehicle may have this vehicle itself offered as a security. A business who has availed a loan for set up of its business may have offered the building office as a security.
2. Floating charge loans:
such loans do not have specific identifiable assets as securities but have a general charge over the companies changing businesses assets such as its receivables or its stock.
An unsecured loan is a loan which is not accompanied by any charge on the assets of the borrower i.e., no asset is offered as security for guarantee of repayment. In case of default of payment by a borrower, lenders of unsecured loans are not automatically entitled to receive any assets of the borrower to fund repayment. The only recourse available to lenders of unsecured loans is to file a legal suit for recovery.
For example, student loans and personal loans offered by several banks and financial institutions are generally unsecured. Such loans are given on the basis of assessment of credit worthiness of the borrower and not on the basis of an underlying collateral.
Differences between secured loan and unsecured loan
The difference between secured loan and unsecured loan has been detailed below:
- Secured loan is a loan which is given on the basis of a security in the form of an asset attached to it, as a guarantee for repayment.
- An unsecured loan is a loan which does not have any asset attached to it as security and is given on the basis of assessment of credit worthiness of the borrower.
2. Charge on assets
- Secured loans have a charge on one or more assets of the borrower – this may be a fixed charge or a floating charge.
- Unsecured loans do not have a charge or lien on any assets of the borrower.
3. Recourse available on repayment default by borrower
- In secured loans, the first recourse available to the lender on default by the borrower is to take possession of the asset offered as security and liquidate it to recover his funds.
- In unsecured loans, the only recourse available to a lender is to file a legal case for recovery of his funds.
4. Surety and guarantee
- Secured loans come with a relative guarantee for repayment in the form of sale value of the security offered.
- Unsecured loans have no guarantee for repayment.
5. Risk to lender
- Secured loans are less risky for the lender as they can recover all or part of their funds by taking possession of and liquidating the assets offered as security.
- Unsecured loans are riskier for the lender as they may lose their funds in case the borrower becomes bankrupt and cannot repay the loan.
6. Risk to borrower
- In the case of secured loans, borrower has higher risk as in case of default on his part; he will lose possession of his asset offered as security.
- In the case of unsecured loans, borrower has a lower risk at the outset. The borrower may still eventually have to liquidate his assets to repay the loan under legal proceedings.
7. Priority in liquidation
- When a company is undergoing liquidation, lenders of secured loans are given priority over lenders of unsecured loans to receive liquidation proceedings.
- Lenders of unsecured loans are lower in priority than lenders of secured loans to receive liquidation proceedings.
8. Interest rates
- Secured loans are less risky for the lender and thus offered at lower interest rates.
- Unsecured loans are more risky for the lender and thus offered at higher interest rates.
9. Borrowing limit and tenure
- Secured loans are generally available for longer tenures and can be drawn up to higher values.
- Unsecured loans are on the other hand available for shorter tenures and up to lower values.
10. Ease of availing
- Secured loans are easier to avail.
- Unsecured loans involve substantiation by the borrower of his creditworthiness and are thus tougher to avail.
11. Offered by
- Secured loans are preferred by lenders when the borrower does not have adequate credit history or his means of repayment are not as robust.
- Unsecured loans are offered by lenders when the borrower has robust credit history and sufficient means for repayment.
- Examples of secured loans include vehicle loan, home mortgage, and several business loans.
- Example of unsecured loans includes credit card debt and student and personal loans.
Conclusion – secured vs unsecured loan:
Banks and financial institutions do their due diligence before granting any loan to its customers, be it a secured loan or unsecured loan. However more detailed enquiry into the credit history as well as sources of income of the borrower need to be done in case of unsecured loans. This makes secured loans a preferred choice for lenders and unsecured loans a preferred choice for borrowers.