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Facts You Should Know About Loan Types
By: Prakash Menon
When you set out to borrow, you often come across terms like unsecured loans,
revolving loans, adjustable rate loans, etc. While these terms are more or less
self-explanatory, it is still useful to be clear on their exact meanings and
what they imply before you finalize a loan contract.
Unsecured versus secured loans
As the name implies, a secured loan is one where you offer collateral of some
kind against the loan. That means, 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 to the lender 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.
All other factors being equal, a secured loan may be offered at a lower interest
rate as compared to an unsecured loan. That’s obviously because of the lower
risk associated with the secured loan -- should you default, the lender has an
asset to fall back on. Sometimes you end up with a choice -- you can take a loan
on either a secured on an unsecured basis. The difference in APRs may be quite
significant in such cases. However, being offered a choice like this is
comparatively rare in consumer financing, but may exist 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.
Adjustable rate versus fixed rate loans
A fixed rate loan is one where the interest rate charged is fixed for the entire
duration of the loan. The advantage is that you are immune to fluctuations in
interest rates and can budget your cash outflows precisely. The disadvantage to
you (the borrower) is that should interest rates fall, you lose in terms of
opportunity costs. That is, you could have obtained a lower interest rate had
you opted for an adjustable rate loan.
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.
An adjustable rate loan is one where the interest charged fluctuates in line
with a benchmark rate. This benchmark rate is usually the Prime Rate, which is
what the US Treasury charges its prime (or best) borrowers. The advantage of an
adjustable rate (or floating rate) loan is that what you are paying is more or
less in line with the market. If interest rates decline, so do your costs and
vice versa. The disadvantage is that your cash outflows for interest are
unpredictable.
As a borrower, if you hold the view that interest rates are going to decline, it
is best to opt for an adjustable rate loan. But arriving at the correct view
consistently is easier said than done. Predicting interest rates is a game where
even professional market participants and institutions frequently go wrong.
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.
About the Author:
Prakash Menon is a financial expert and writer specializing in managing personal
debt and providing wealth building solutions. He has written on cash advances,
personal debt management and other topics. See http://www.payday-cashadvances.net
for the 10 things you must look into before you take a payday loan. |
