For those with no previous experience, understanding the facts and choosing the right type of loan can be overwhelming and pretty confusing. Nothing is worse than notarizing loan papers only to realize months later that this is not the loan you had been anticipating. Avoid any confusion by getting the facts sorted out before you even go any further in your search.
Loans can be categorized into two broad categories - secured and unsecured. The primary difference between the two loan types is whether the loan is guaranteed with a claim against some type of identifiable asset, or is solely based on the creditworthiness of the borrower. Either type of loan creates a legally enforceable debt between the lender and the borrower. The difference between the two loan types is most visible when a borrower does not repay the loan based on the loan guidelines, and the lender pursues other means to satisfy the outstanding debt.
What is a Secured Loan?
A secured loan is backed by a lien, or claim against some asset which is owned by the borrower. Lenders typically require this when the creditworthiness of the borrower is in question. The loan is granted in anticipation of the borrower acquiring a specific asset, or the loan amount necessitates its securitization. The security gives the lender a legal right to seize a borrower's specific asset in case the borrower defaults on the loan. The asset is considered encumbered, which means it typically cannot be sold or transferred by the borrower without the lender's permission, unless the debt is paid off. If the asset is transferred without the debt being repaid, the new owner takes possession of the asset subject to the lender's lien. A lender can pursue legal action to take possession of an asset identified in a secured loan agreement if the borrower defaults. Taking possession allows the lender to sell the asset and satisfy the outstanding debt. If the sales proceeds exceed the outstanding loan amount, the lender must legally give the excess funds to the borrower.
What is an Unsecured Loan?
An unsecured loan is made between lender and borrower solely based on the promise of the borrower to repay the loan. Lenders make this type of loan based on their assessment of the borrower's creditworthiness and ability to repay the debt. Typically, credit cards are prime examples of unsecured loans. The borrower is loaned money by the lender to make purchases, take or repay another creditor via a balance transfer. A balance transfer is simply paying one credit card balance off with another loan from a different lender. In case of borrower default, the lender cannot seize any of the borrower's specific assets, but can attempt collection through prescribed methods and report any default amount to the various credit reporting agencies, which will negatively affect the borrower's credit score. You can also get which is a small loan that must be paid back in full on your next payday, these can be very good if you are short on cash till your next payday.
So Which Loan is Better?
If you are looking for a way to pay another creditor or simply working on building your credit back up, an unsecured loan is likely a good choice. If you default on this loan for any reason, you will not lose an asset (like your house or car) though you will still be accountable for paying it back.
The key to remember is that doing the research and reading the fine print in the beginning will pay off in the end. In the unthinkable event that some financial crisis hits you and you default on your loan, you need to know the consequences. Take your time and make sure you are making the best choice, you can always consult with a financial advisor before taking the leap.