What are the different types of loans?

People borrow money for various reasons. It could be to expand their business, to fund higher education, to buy a home or car, to get a ring for their girlfriend or wife.

Loans generally fall into two categories, secured and unsecured. Let us first understand what a secure loan is.

Secured loans are those for which a borrower keeps some asset as surety or collateral to borrow money. Collateral can be your car, your home, or anything that is valuable.

It simply means that in the event of default, the lender can use the asset to repay the funds it has advanced the borrower.

Common types of secured loans are mortgages and auto loans, in which the item being financed becomes the collateral for the financing. With a car loan, if the borrower defaults on the payment, the loan issuer can seize the vehicle.

When an individual or business takes a mortgage, the property in question is used to back the repayment terms. In fact, the lending institution maintains equity in the property until the mortgage is paid in full. If the borrower defaults on the payments, the lender can seize the property and sell it to recoup the funds owed.

Now, let us talk about unsecured loans. Unlike the secured loans, unsecured loans are taken without keeping a collateral. If the borrower defaults on this type of debt, the lender initiates a lawsuit to collect what is owed. Lenders give funds in an unsecured loan solely on the borrower’s creditworthiness and promise to repay.

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Banks charge a higher interest rate on the unsecured loans as they are high risk. Also, credit score and debt-to-income requirements are usually stricter for these types of loans.

While giving unsecured loans, banks check credit history of the borrower. Any past default may lead to cancellation of the loan. Apart from that, the borrower’s financial condition is also checked to find out if he will be able to repay the loan.

Examples of unsecured loans are personal loan, education loan and credit card transactions. And when a bank finds that a loan or outstanding money owed are no longer recoverable, it marks is as a bad loan.

The RBI recently said in an RTI reply that banks have written off a whopping Rs 11,68,095 crore worth of bad loans in the last 10 years. Apparently, most of them were unsecured loans.

People who don’t want to pledge their assets or don’t have property to apply for a secured loan, opt for the unsecured loan. It is a good option if you are looking for immediate cash.

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