One should always carefully consider their personal circumstances when deciding to take on new debt
Sanderson Abel
A secured loan is one that has collateral attached to it.
Ordinarily, this type of loan generally has a comparatively lower interest rate because the bank is taking a lower risk because the bank can call upon the collateral in the event of default. Unsecured loans are not attached to any collateral. They are unsecured because the bank has nothing to go after if you default.
Unlike mortgage finance which is normally secured by the house, unsecured loans are simply given on the borrower’s word to repay.
There are always contracts to sign but there is nothing the bank can seize if the borrower fails to repay the money lent.
Importance of borrowers’
creditworthiness
An unsecured loan is that loan issued and supported only by the borrower’s creditworthiness, rather than by a type of collateral.
An unsecured loan is one that is obtained without the use of property as collateral for the loan. Borrowers generally must have high credit ratings to be approved for an unsecured loan. These types of loans are called signature loans or personal loans. Because an unsecured loan is not guaranteed by any type of property, these loans are bigger risks for lenders and, as such, typically have higher interest rates than secured loans (such as a mortgage).
Although the interest rates are higher, the rates may still be lower than those of credit cards. Unlike mortgage loans, the interest on an unsecured loan is not tax deductible. An unsecured loan may have a fixed interest rate and be due at the end of a specified term, or it can exist as a revolving line of credit with a variable interest rate.
In most cases, unsecured loans are considered somewhat high-risky, since the lender does not usually have any way of forcing the borrower to comply with the terms or make payments on time short of legal action. For this reason, most unsecured loans carry relatively high interest rates and are often only available to those with strong credit scores.
Why opt for unsecured loan?
Unsecured loans are used primarily for small, short-term expenses, such as medical crises or purchase of household property or funeral costs.
They are usually intended to be paid back within about a year, though the terms can vary depending on the amount at issue and the relationship between the lender and the borrower. When borrowers do not have a lot of valuable property, pursuing an unsecured loan may be one of their only ways of getting access to needed funds.
When only small amounts of money are on issue, it is not usually worth the hassle of transferring property titles and establishing a collateral relationship. A simple contract can often be the best way to proceed, even if there is other trade-offs. It should be understood by the bank client that the ultimate decision on what type of loan to choose lies with him either to go secured or unsecured. You should always give careful consideration to your personal circumstances when deciding to take on new debt and always borrow the least amount of money possible.
Advantages of unsecured loans
You can normally qualify for an unsecured loan without having substantial assets.
- Since there is no collateral required, you do not risk losing any personal property such as a home or car.
- Unsecured loans are a better option for consumers who only need to borrow a small amount.
- Simplicity is another reason to seek an unsecured loan
- Disadvantages of an
- unsecured loan
- The repayment period is usually shorter than with a secured loan resulting in higher payment amounts.
- Since there is no collateral required, lenders normally charge higher interest rates for unsecured loans.
- Qualifying for an unsecured loan is generally more difficult.
- Available to those with strong credit scores
It is important to understand that unsecured loans are riskier than secured loans because the lender does not have the ability to seize an asset right away if a borrower fails to repay the debt. Creditors may of course sue to obtain access to accounts or other assets if the borrower has not paid, but that is more expensive than requiring collateral up front. Regardless, this lack of security increases the creditor’s risk, which in turn increases the interest rates on unsecured loans.
Given the debilitating effects of non-performing loans, banks have to adopt a cautious approach to lending. The whole problem emanates from asymmetric information and adverse selection problem. This challenge is being resolved through creation of the national credit registry system. These will be the custodians of the credit information for each and every borrower. It will be easier for the banks and other credit providers to have credit score for each individual and companies. This will then alleviate the moral hazard and adverse selection problem in the financial system hence minimising financial instability.
It would make it easier to advance unsecured to those with good credit record while those with tainted credit rating will find it difficult to access unsecured funding.
- Sanderson Abel is an Economist. He writes in his capacity as Senior Economist for the Bankers Association of Zimbabwe. For your valuable feedback and comments related to this article, he can be contacted on abel@baz.org.zw or on numbers 04-744686 and 0772463008.