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  • Facts You Should Know About Types of Loans

     

    Unsecured versus secured loans

    As the name implies, a secured loan is one where you offer some kind of collateral against the loan. The agreement is that if you default on the loan, the lender has the right (but not the obligation) to take possession of the asset you have pledged.

    In most cases, this asset would be what the lender has financed. For example, when you take a home loan, you offer the home as collateral.

    There may also be cases where you may need to offer additional collateral over and above the asset that is being financed. This happens, for example, when the lender is financing close to 100% of an asset that is prone to rapid reduction in market value. In such cases, the lender may insist on your putting up another asset so as to provide a reasonable margin of protection in case of default.

    Unsecured loans are those where such collateral arrangements do not exist. These loans are granted based on your credit standing, ability to repay and other factors.

    In cases where there's a choice available to the customer to take either a secured or an unsecured loan, the former may be offered at a somewhat lower rate. That is, assuming every other factor remains equal. This is because of the lower risk involved to the lender, who has recourse to a specific asset in case you default. However, this situation is comparatively rare in consumer financing, although it is more common in financing businesses.

    Installment versus revolving loans

    A revolving loan is one where you have access to a continuous source of credit, up to a pre-determined credit limit. If the limit is say, $10,000, you can borrow any amount up to $10,000. And typically, you can repay all or part of the amount you borrowed at a time of your choosing, within the overall tenor of the loan.

    You pay interest only on the amount you borrow for the time you borrow it. Sometimes, banks may charge a commitment fee for making a revolving line of credit available to you. This fee is usually charged on the average unutilized amount of your limit.

    You can also re-borrow the amount you have repaid. In effect, you have a loan that's always available to you on demand.

    Unlike revolving loans, installment loans have a fixed repayment schedule. In most cases, the full amount of the loan is drawn down (i. e., borrowed) at once and both repayment schedule and amounts are fixed in advance. You do not have the option to re-borrow the amount that has been repaid.

    In practice, you can always choose to refinance the fixed rate loan at a lower rate if interest rates fall sharply enough to justify it. Bear in mind that your current lender may charge a pre-payment fee if you choose to repay before due date. So the difference in interest rates between your old fixed rate loan and the new loan should be large enough to justify a switch.

    If it is important to you to be able to budget for your interest obligations in advance, a fixed rate loan may be the best choice. After all, you can refinance it should the interest rates fall significantly.

    Keeping these basic facts in mind should help you make more informed borrowing decisions.

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