You must be aware that ‘Personal loans’ have higher interest rates compared to other categories of loans like – Home Loan, Auto Loan, Education Loan and so on. Did you ever thought why a personal loan is usually offered as a much higher interest rate compared to other types of loans available in the market? Why the banks are more interested in offering personal loan only to individuals with excellent credit scores? Why does it take so much time to process a personal loan compared to a Home or an auto loan?
Let’s try to drill down and figure out the primary reasons behind this unique (but universal) trend of banks across the globe.
Before I jump to the answers, l would like to introduce two generic banking terms which are important to understand for resolving all the above questions:
- Secured Limit
- Unsecured Limit
I am sure that you would have heard of these two keywords at least once (if not often) in your lifetime. As we see, that these are two different types of limits offered to individuals by the banks.
A secured limit is one that is offered based on the number of collateral that a borrower produces and the present market value of those collateral.
To understand this, lets take an example- assume, a person has a CAR worth $30,000 and a House worth $ 150,000 and he produced these two as collaterals to get a loan from the bank. The bank would maintain the details of these collaterals in its system and calculate the sum of total present value of the collateral, in the above case the total present value of the collateral would be $ 180,000.
Now, the bank would also keep some margin aside due to market fluctuations or other costs involved in this process, let’s assume the bank wants to keep a margin of 20 percentage (which is equal to 20% of $180,000 = $ 36,000). So, remaining amount would be $ 144,000 ($ 180,000 – $ 36,000). This is the amount for which bank can easily approve a secured borrowing limit for its customer.
At any time, if the customer wants to avail a loan, the bank can easily offer a secured loan uptill $ 144,000. However, if the borrower does not make repayment of the loan amount, the bank may auction the linked collaterals in the secondary market to obtain the due (or loan outstanding) amount.
So, through the above example it is evident that – “Any loan which is backed by a collateral is called a secured loan”. Now, let’s understand what are the key advantages of offering secured loans for a bank:
- Backed by collateral, so lesser risk involved in issuing the loan to the borrowers.
- Chances of nonpayment are less, as the borrower knows that it may lead to auction of his linked collaterals.
- If the secured limit is not utilized completely by the borrower, the bank may sell its other products like credit card, overdraft within the available limit.
- In case of appreciation of the collateral value, the bank can re-evaluate the current market value of property and increase the limit amount accordingly. This, therefore gives more opportunity to banks for selling more number of secured products to its existing borrowers.
- Few collateral like bonds and stocks have maturity date, the bank can easily keep track of expiry dates of such collaterals in the system and send notification to borrowers for producing more collaterals to continue with credit facilities.
All the above advantages make secured loans more popular and safer for the banks. This is also the reason, why most secured loans like car or a home loan gets approved quickly as the financial risk is quite low and the collateral are usually hypothecated with the banks.
For any lending product, banks across the globe operates on one universal rule -“Greater the risk, higher the rate”. As secured loans, have the least risk factors in it, the bank generally offers them at least possible interest rates.
With this, let’s list down the advantages of a secured loans for borrowers:
- Loans are offered at lesser interest rates.
- Borrowers may obtain higher limits based on collateral value.
- Quick and hassle-free loan approval process.
- Borrowers may obtains facilities like -loans, credit cards, overdraft facilities even with average or below average credit scores as well.
- Over the period of time, borrowers may request to increase the loan amount or the credit limit with the increase in collateral value.
- If in case the borrower is unable to repay the loan and the bank auctions the linked collateral, the difference amount (i.e. Current Market Value – Loan Total Due Amount) is given back to the borrower.
Now, that we understand what a secured limit is and how it help banks and borrowers in a lending process, let’s move on to the next keyword – ‘Unsecured Limit’
An unsecured limit is a credit limit offered by a bank to the borrowers without linking any underlying collateral (or assets). Typically, these limits are offered completely based on the assessment conducted on various indicators of borrower credit profile like – past repayment history, sources of income, credit score, working experience, reputation of the employer, background verification, purpose of loan and so on.
The underwriting team of the bank performs a thorough examination of borrower’s profile and finds out if the prospect is suitable for issuing an unsecured loan without more financial risk, if yes then, maximum limit that may be offered based on . The results of bank’s underwriting team is then sent further for verifications and approvals. Only if all the approvals are received, the loans are offered to borrowers.
Therefore, the processing time of unsecured loans usually takes more time compared to unsecured loan. Also, due to high risk involved in unsecured loan, the borrowers are offered loans at higher interest rates.
Advantage of Unsecured Loans for borrower:
No collateral required
The borrower is not required to produce any collateral for getting the loan. The bank provides loan based on past repayment history, credit score and many other factors that makes borrower suitable for granting the loan.
Disadvantage of unsecured loan for borrower:
High interest rates
Unsecured loans are offered at high interest rates compared to secured loan due to high risk involve in offering such loans. The processing fee of unsecured loans are also quite high as it involves an comprehensive verification and underwriting process.
As we now completely understand what a Secured and Unsecured loans are? We are good to discuss about Partially Secured Loans:
To understand this, lets take the same example as above:
if a person has a CAR worth $30,000 and a House worth $ 150,000 and he produces these as collateral in the bank. Total present value of the collateral would be $ 180,000. After keeping a margin of 20 percentage, which is equal to $ 36,000 the remaining would be $ 144,000.
So any loan offered upto $ 144,000 is secured; however if the borrower requests a loan of $ 200,000, the bank may still decide to offer this amount based on borrower’s credit score, repayment capacity and relationship. This category of loan which is partially backed by collateral are known as Partially secured loans.
A partially secured loan are generally offered with great benefits for the borrowers. You can easily check the competitive rates offered for partially secured loans through online advertisements, posts or official websites of different banks.
Below are few key benefits of partially secured loans:
- Comparatively Lesser interest rates
Since Partially secured loans are partly backed by collaterals or assets, the banks are exposed to lesser risk and therefore these loans are offered at comparatively lesser rates to the borrowers.
- Loan availment greater than collateral value
In case of Partially secured loans, the borrowers are not required to produce the collateral to the extent of complete loan value. So, the borrower can user the collateral for other purposes.
- Good Products and great offers
A borrower with Partially secure loans are generally offered high quality products (credit cards, overdraft, loans, Deposits) available in the market as they are considered as a group of individuals who are high net worth, maintains good credit ratings, have excellent repayment history and high social status.
- Quick and simple Loan Processing
Compared to unsecured loans, partially secured loans have simpler and quicker approval process. The documents required for processing loan applications are also comparatively less and some time the borrowers are offered pre-qualified loans at reasonably lesser interest rates.
- Lesser Processing fees and other miscellaneous charges
Usually the loan processing fees, APR, and other miscellaneous bank charges are comparatively lesser throughout life time of loan. The bank also offers additional services for partially secured loans like loan top up, rescheduling, pre-closure etc less prices.