What is unsecured lending and how does it work?
“Financial freedom is a mental, emotional, and educational process”.
First, let’s understand what loan means?
In simple words, the loan is when you receive money from a friend, bank, or financial institution in exchange for further repayment of the principal, plus interest and tenure duration. The principal is the amount which you have borrowed; interest is the amount charged for receiving the loan, and tenure is the time duration of the loan.
Classification of loan.
Loans are divided into two categories
- Secured loan
- Unsecured loans
What is a Secured Loan?
A secured loan or secured debt is when the borrower commits to giving the lender certain assets, that could be real estate, property or a car. If he or she fails to make the payment then the lender seizes the asset and can sell it to recoup the money lent. A secured loan is backed by collateral.
What is an Unsecured Loan?
An unsecured loan is a loan that is not backed by collateral to guarantee the repayment. Unsecured loans are given on the creditworthiness of the person. The creditworthiness of the borrower is assessed based on the five C’s of credit: character, capacity, capital, collateral, and conditions.
The picture below gives a clear distinction between secured and unsecured lending :
Unsecured loans are loans which do not require collateral. Instead of making assets mortgage, the borrower has to qualify based on his creditworthiness and income. The loan department does not have any right to take away the physical assets (house, vehicle, gold) if the borrower stops making the payment on an unsecured loan. The other name of unsecured loans is signature loans or personal loans which do not require assets as collateral. Borrowers must generally have high credit ratings to be approved for certain unsecured loans. And therefore, the banks charge a higher rate of interest on these loans as compared to secured loans. Some of the examples of unsecured loans include Education loan, Business loan, Personal loan, Credit Cards, etc.
Features of an Unsecured Loan:
- These loans are given based on creditworthiness and repayment history, other criteria may also be considered.
- The tenure of the loan is usually flexible and the time duration could be from 1-5 years or more.
- These loans are given without collateral.
- Unsecured loans have a high rate of interest as the risk taken by the lending bank is high.
- The amount could vary from Rs. 1-2 lakh and go up to Rs. 45-50 Lakh, depending on the business and the size of business.
- Many banks offer overdraft facility with an unsecured loan.
- The public company, private company, and partnership company can apply for an unsecured loan for business purposes.
- An only well-established company can opt for an unsecured loan.
Note: Different banks have different criteria for an unsecured loan, but here are some common features of these loans.
- The person should have a basic minimum salary. Higher the income the more loan amount you get.
- The person should have a strong credit score. The credit score represents the repayment capacity of the individual.
- The person should have a stable job. In the case of business, the business should be operating for at least 3 years.
Factors to be considered before opting for an unsecured loan:
The business should be operational for at least 3 years. Stable business is referred more for an unsecured loan when it is been compared with newer organizations.
2. Credit score
Before lending unsecured loan the creditworthiness of a person is taken into consideration. The score is based on loan and the credit payments made by the applicant. It is been measured on a scale of 900 points. Individuals with a credit score of 750 points or above are considered loan worthy.
Some banks require to know the applicant’s minimum salary bracket only then they would be granted an unsecured loan.
Youngsters are considered to be risky investors as they do not have a strong business network. So banks think before lending loans to them and they do check the creditworthiness of the person.
5. Business with a bank account
Bank prefers to give loan to those who have their bank account so the bank can cross verify regarding the bank details.
6. Unsecured loans are for short term tenure.
An unsecured loan can be availed for a limited tenure. The maximum time limit could be for 5 years, in the worst case.
7. A bad credit score
The person with a bad credit score will find it very difficult to avail of a loan. Because in unsecured loans there is no such thing called collateral and the risk is higher for the bank because they won’t be able to recover money.
The rate of interest on an unsecured loan is high because there is no collateral and so the banks consider it to be a risky investment. So high interest is charged by the banks when they give an unsecured loan.
9. Ideally, the loan is not for startups
An unsecured loan is not for startups entrepreneurs. Banks do check credit worthiness and repayment history of the applicant.
Advantages of Unsecured Loan.
- The first and foremost advantage the borrower gets is there is no need for collateral, wherein if the person is not able to repay the loan the bank does not seize the assets.
- Unsecured loans get approved quickly. Higher the income, higher the amount of loan gets granted. There is no need for other formalities to be done.
Disadvantages of Unsecured Loan
- Unsecured loans carry a very high rate of interest on the borrowed amount.
- The person needs to be careful while he is making payment of installments which implies that the borrower has to be disciplined while he is making repayment of loan installments.
- These loans are without securities so if the person is failing to repay the loan amount the loan interest would be increased tremendously.
The applicant should have a strong credit score. Because if the credit score is below 750 the applicant won’t be eligible for a loan. The applicant should have a job with a minimum salary slab. In the case of entrepreneurs, their business should be for at least 3 years. And business should be based in India.