In one way or another, almost every person in the world uses a loan. Unfortunately, the majority of them have no clue about the specifics of the loan that they’re taking. At best, they understand their interest rate and the way in which credit payments work. However, the bulk of this is determined beforehand, while they’re still applying for the loan. The terms that they get, the amount of money that they have to return and more, greatly depend on the type of loan that they opt for.
Now, there are many different divisions when it comes to the types of loan or loans you might need, depending on your classification criterion. Based on the assurance that you offer to the lender, there are two major types of loans – secured and unsecured. Here are a couple of things you need to know about each of these types in order to be able to make up your mind.
1. What is a secured loan?
A secured loan is a scenario where a borrower provides a lender with collateral as a guarantee that they’re going to return the money. The guarantee in question is called collateral and it is usually a valuable asset that’s owned by the borrower. Collateral can be a property that you own, a vehicle that you own, as well as the mortgage or a car loan that you’ve partially paid off. Keep in mind, though, that this collateral is not just for the show. In a scenario where you can’t meet the payment, the collateral in question will go to the lender as compensation.
The way in which this works is fairly simple and straightforward. Instead of selling the collateral in question in order to get the funds, what you do is use them as an assurance in order to get a loan. By selling the property, for instance, you would lose it indefinitely. However, by using it to get the loan you still keep the ownership for as long as you make your payments.
One way people take advantage of the equity in their home is through a reverse mortgage. You can stop your mortgage payment and use your home as a form of income. This can be especially helpful for those on a fixed income. For as long as you’re diligent, you get to keep your assets, improve your credit score (something we’ll discuss later on) and use the money that you’ve borrowed.
Secured loans have many advantages, ranging from the fact that you’re more likely to get better terms for your loan. This is due to the fact that the lender knows that they’re getting their money back, one way or another. So, you may borrow more and pay it back over a longer period of time, thus making a monthly credit payment much easier to make. Then, there the issue of credit rating. People with poor credit rating may be able to get a good loan much easier this way, as we’ve already hinted, this could also be a way for them to improve their credit score.
2. What is an unsecured loan?
Next, we come to the issue of unsecured personal loans. After we’ve already elaborately explained what secured business loans are, it’s easy to describe unsecured business loan as a loan that you get approved for without having to offer collateral. Instead, you usually have to have a great credit score, as the assurance that you will indeed return the money. In this day and age, however, it’s fairly easy to find a lender that’s willing to work even with those who have a bad credit score, even though you’re likely to get bad credit score this way. Other than unsecured personal loans, two other common types of unsecured loans are credit cards and student loans.
Due to the fact that the collateral is not used in the unsecured loan, the lender is taking a much greater risk. Sure, even with the flawless credit history and a great credit score, chances are that you may not return the money (not necessarily by your own fault). Seeing as how there’s no collateral for them to collect, sell and get their money back, the lender is exposing themselves to a great risk. The more money they agree to lend you, the greater the risk for them it will be. You should also keep in mind that this is what makes it a lot harder to get approved for a good unsecured loan.
The advantages of unsecured loans are quite numerous, as well. First of all, you don’t have to be a homeowner in order to apply for an unsecured loan. Second, you’re not risking collateral, which may be the most valuable asset that you own. A lot of people are reluctant to go for a secured business loan, even if they have the collateral to offer, merely because they are aware of just how serious the consequences of not meeting the payment are. In other words, while secured loans are much safer for the lender, unsecured loans are much safer for the borrower.
3. The downsides
The downsides of secured credit loans are quite serious, due to the fact that, in the worst-case scenario, you’re exposed to the risk of losing a valuable asset. The feeling of being in debt is bad enough, even without having to worry about losing your home or your car. Other than this, you may lack the necessary collateral to begin with, which means that you may not qualify for a secured loan.
Out of all the downsides of unsecured loans, there are three that stand out the most. First, you usually get to pay a higher interest rate. Look at it this way, the greater the risk that a business takes, the more profit they expect and this is true for your lender, as well. As we’ve already mentioned, with a secured loan you get to borrow more money at one time. For obvious reasons, the majority of unsecured business loan lenders seldom offer loans greater than $25,000 (although there are exceptions). Third, there’s usually less flexibility with unsecured loans. For instance, in a scenario where you decide to return the loan somewhat sooner, you might face an early repayment fee.
4. Credit score
So far, we’ve mentioned the concept of credit score several times, which is why it’s the right time to discuss the term itself. Simply put, your credit score is your financial trustworthiness put on a scale that the potential lender can read. This way, they can make an estimate of just how safe it is for them to borrow you the money, as well as just how likely they are to get their money back (or get their money back in time). This will determine the terms under which you’ve borrowed the money, as well as whether you’re borrowed the money in question, to begin with.
While there are many different types of credit score out there, the most popular, as well as the most commonly used scale is the so-called FICO score. The FICO score uses the numerical range between 300 and 850 where the higher score means a better credit rating. In general, the FICO score between 800 and 850 is considered to be exceptional. The score between 740 and 799 is considered to be very good, while the score between 670 and 739 is considered to be good. The score between 580 and 669 is fair, while score bellow 579 is considered to be very poor. Keep in mind that the higher your score is, the harder it will be hit by any missed payment. For instance, if you have an exceptional, a single missed payment can bring it down by as much as 100.
The last thing we need to consider is the question of what goes into your FICO score or how it is determined. There are five crucial factors to determine your credit history. First, you have the payment history which is about 35 percent of the entire score. Then, you have the current loan and credit card debt, which is about 30 percent of the score. About 15 percent of the credit score is determined by the length of your credit history (the longer it is the better it is for your score, seeing as how it makes it more reliable). The types of credit that you currently have are another 10 percent of the score. Finally, the new credit is the last 10 percent.
5. What happens if you default? (300)
Now, we come to the issue that probably interests everyone the most, which is – what happens in each of these scenarios if you default? Loan default is a scenario in which the borrower fails to pay back a debt in the terms that were previously agreed upon. One more term that you have to get acquainted with here is the one of delinquency. Simply put, this is the period of time between missing the loan and having the loan default. This should always be clearly stated in the contract. Keep in mind that even if you haven’t breached your delinquency yet, as soon as you miss a loan payment, your credit rating starts to suffer.
With a secured loan, if you default, the lender has the legal right to take possession of your collateral. In a scenario where we’re talking about the mortgage, the lender takes control of the property in question, while, if there’s a car loan involved, they can take the possession of your vehicle. Previously, we’ve mentioned the fact that you need a good credit score in order to apply for an unsecured loan, while for the secured loan, you may not need a good credit score, to begin with. However, not paying your secured loan in time can have a negative impact on your default.
As far as your credit score goes, unsecured loans act in the same way as with secured loans. This means that the option that the lender is usually left with is to collect on your accounts or take legal action against you in order to return at least some of the money that they’ve borrowed you. Having such an ongoing lawsuit will make it even more difficult for you to get another loan, even though a hit that your credit score will take might be enough to ensure this on its own.
Lastly, you need to keep in mind that there are a couple of alternatives to getting a loan (secured or unsecured) that you need to be aware of. For instance, getting a 0 percent purchases credit card is one of these options. The reason why this is such a great idea is due to the fact that you get to pay no interest rate on the money you borrow. Other than this, there’s the bank overdraft, which is virtually getting the money from your account bellow the balance of zero. A bank overdraft is a scenario where you withdraw the money from your account below zero.
Then, you can always borrow money from family and friends. Here, instead of needing collateral or a credit score, you can use your personal history to vouch for your trustworthiness. Most often there’s no interest rate involved and there’s more flexibility when it comes to paying the loan back. A loving parent may turn a blind eye to a missed payment if they know that their child is struggling financially at the moment. On the other hand, knowing that you’re putting someone that you care about in trouble is bad enough. You may deteriorate a personal relationship this way, which could be far worse. Lastly, they may lack this kind of funds, to begin with.
In the end, as you can see, there are so many variables to consider when choosing the type of loan that’s the best for you. If you don’t have a stellar credit score and you need a hefty loan that you’ll be able to repay over the long period of time, a secured loan might be an obvious choice. On the other hand, if your credit score is decent and you dislike the idea of putting valuable collateral on the line, an unsecured loan might be a better option. After all, the global economy is never 100 percent reliable, which is why you might like the idea of taking as few chances as possible.