Facts You Should Know About Types of Loans

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 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.

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 payday loans, personal debt management and other related topics.

Margin loans not deterring investors NEWS.com.au, Australia - 12 hours ago By Tim Blue WITH Australia's share market in continuing turmoil, investors in margin loans have had a torrid six weeks yet appear to be emerging bloodied ... Australians 'wealthier' than ever before Sydney Morning Herald all 27 news articles

Allianz Eyeing Chances to Buy ABS, Leveraged Loans Reuters - 3 hours ago DE: Quote, Profile, Research) is actively looking to buy leveraged loans and asset-backed securities (ABS) whose prices have been driven down by the turmoil ...

Earthtimes

Interest rates: The new conundrum CNNMoney.com - 1 hour ago These low long-term rates helped fuel the home building boom and the credit market's appetite for securities backed by increasingly riskier mortgage loans. ... Bernanke's Surprise Gold Seek Treasury Two-Year Notes Can't Escape Faster Inflation (Update1) Bloomberg Loans make up most of collateral posted at Fed: report KPLC-TV all 105 news articles

New initiative to offer NIS 400m. in loans to businesses in North Jerusalem Post, Israel - 10 hours ago By HAVIV RETTIG A new initiative seeks to offer loans to some 85000 small businesses in the North still reeling from losses incurred during the Second ...

Fed’s collateral book mostly in loans Financial Times (subscription), UK - 11 hours ago ... made by the Federal Reserve to banks operating in the US is in the form of loans rather than securities, the New York Fed has told the Financial Times. ...

Mortgage crisis spills over into school loans Boston Globe, United States - 20 hours ago With financial aid packages going out to students over the next few weeks, financial aid directors are urging families to move quickly to line up loans ...

Mortgage crisis squeezes student loans Seattle Times, United States - Feb 24, 2008 The credit crunch, which started with a panic over people missing home-loan payments several months ago, has spread like a disease, infecting a broad range ...

ARCIL to acquire Rs 2000 cr worth bad loans in FY08 Economic Times, India - Feb 24, 2008 Arcil has acquired bad loans valued at Rs 1600 crore so far this fiscal (FY 08) from around four deals, and enjoys a dominating 80 per cent market share in ... UCO Bank to clean up balance sheet Economic Times all 3 news articles

AGRI DEVELOPMENT BANK OF CHINA GIVES US$3.7 BLN OF GREEN LOANS Trading Markets (press release), CA - 29 minutes ago In 2007, ADBC provided a total of 2.31 billion yuan of loans to 77 rural energy projects, all of which are renewable energy developments. ...

No loans for many students The Brown Daily Herald, RI - 37 minutes ago An $11.5 million increase to the financial aid budget will mean fewer loans and less debt for financial aid recipients, starting next fall. ...