Difference Between Secured Loan vs Unsecured Loan
The following article provides an outline for Secured Loan vs Unsecured Loan. Secured Loan refers to the borrower’s borrowing from the lender, which is secured by way of mortgage or pledge or hypothecation or lien mark of certain collateral assets, which can take different forms in terms of being tangible or intangible. Such collateral assets can be liquid collateral such as Marketable Securities or fixed Assets such as Buildings, Factories, etc., which are not that liquid in nature. In short, lending, which is secured by eligible collateral, is called Secured loans. Common examples of Secured loans include Home Loan, Vehicle Loan, etc.
Unsecured Loan refers to the borrower’s borrowing from the lender without any collateral underlying such loan. Due to the higher risk involved in the borrower’s case of default, such loans carry a higher rate of interest compared to Secured Loan to compensate the lender for the additional amount of risk undertaken. One of the most common types of Unsecured Loan is a Personal Loan which is offered by almost all type of Financial Institutions as well as new-age Fintech companies to meet the varied needs of borrowers.
What is a Secured Loan?
The name Secured Loan itself defines the characteristics of such a loan. A Secured Loan is a loan that is secured by underlying collateral, which can be either offered as a prime asset or offered as collateral to the lender against the amount borrowed. Also secured loan provides a cushion to the lender as they can fall upon such collateral in the event of any default to reduce their overall risk exposure and risky proposition.
Normally big-ticket loans require collaterals in the form of eligible security and, as such, are more secured in nature. An important thing to remember is that just because any underlying collateral secures a loan doesn’t make it risk-free and financial institution have to set aside a portion of their capital for such assets denoted in terms of a concept called Risk-Weighted Assets, which signifies the risk of such secured assets.
What is an Unsecured Loan?
Unsecured Loans are characterized by no underlying security and are normally of small ticket size, which can go as high as a few million Indian currencies. These are normally given for various miscellaneous purposes but usually are non-business and given mostly to retails borrowers with a credible credit history and high credit score demonstrating repayment capacity.
Credit Card and Personal Loans are some of the popular types of Unsecured Loans, and these carry high-interest income for financial institutions due to the high interest rates being charged on such loans. These loans also carry a high amount of capital for the financial institution to set aside, denoted in terms of Risk-Weighted Assets.
Head to Head Comparison between Secured Loan vs Unsecured Loan (Infographics)
Below are the top 5 differences between Secured Loan vs Unsecured Loan:
Key Differences between Secured Loan vs Unsecured Loan
Despite the inherent differences as enumerated above in the Secured Loan and Unsecured Loan, the similarities lie in the following areas:
- Both require a high level of credit underwriting with a focus on the repayment capacity of counterparty borrowers.
- Both require a high credit score of the borrower to be eligible for availing such a loan (although the eligibility criteria vary within different Financial Institutions)
Secured Loan vs Unsecured Loan Comparison Table
Below are the key differences between the two types as enumerated below:
|Underlying Asset||These loans are backed by underlying assets known as collateral, which can take different forms and be liquid or Illiquid.||These loans are not backed by any underlying assets known as collateral and are completely unsecured.|
|Credit Risk||Secured Loans have comparatively less amount of credit risk compared to Unsecured Loans due to underlying collateral, which can be liquidated in the unlikely event of default by the borrower.||Unsecured Loans have a higher level of risk compared to Secured Loans as there is no underlying asset to fall back by the lender in the unlikely event of default by the borrower.|
|Capital Provisioning||Secured loans require less capital provisioning (computed based on the Risk Weight Assets) by Banks and Financial Institutions.||Unsecured loans require more capital provisioning (computed based on the Risk Weight Assets) by Banks and Financial Institutions.|
|Loss given default||In the case of a Secured Loan, the likely loss given default is less for Banks and Financial Institutions as the Net exposure is a reduced amount after adjusting for the collateral.
For instance, A Bank has given a loan of $10 million for the purchase of a house that the borrower has mortgaged to the Bank. The current valueof the House is $7 million. Assuming there is no haircut, the Net Exposure of the Bank for this secured loan will be $3 million, and accordingly, less amount of capital provisioning will be required.
|In the case of an Unsecured loan, the likely loss given default is high for banks and Financial Institutions as the Net exposure is the same as the original exposure due to no underlying collateral.|
|Interest Rate and quantum of loan||Secured Loans carry lower interest rates, and the quantum of the loan amount is normally high in these cases. The majority of the lending is normally secured.||Unsecured Loans carry higher interest rates, and the quantum of the loan amount is normally low in this case due to the inherent high-risk structure of such loans. Unsecured Loan forms a small proportion of the lending portfolio in the majority of the full-scale commercial banks.|
Secured Loans and Unsecured Loans are a part of any Bank or financial institution’s lending portfolio and complement each other. Unsecured Loans act as a building block in creating a good credit history of the borrower and for the lender to assess and cultivate credit discipline in the borrower, which enables lending institutions to fund Secured Loans at a later date. However, this chronology doesn’t happen in all cases; however, it surely helps Lending Institutions and acts as one of the factors while making underwriting decisions.
This is a guide to Secured Loan vs Unsecured Loan. Here we also discuss the secured loan vs unsecured loan key differences with infographics and a comparison table. You may also have a look at the following articles to learn more –