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 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.
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.
