What is an unsecured loan?

An unsecured loan, as the name implies, is a loan offered by a bank or other financial institution without securing a safety deposit or collateral from the customer.  When a bank offers a housing loan, it keeps the property as collateral until the entire loan has been paid off. Similarly, in auto loans, the ownership papers of the vehicle are transferred only once the loan has been repaid. In the case of unsecured loans, the lender does not hold any asset of the customer as collateral in case of default on payments.

What are the different kinds of unsecured loans?

There two main types of unsecured loans for individuals are personal loans and credit cards. Sometimes, lenders offer unsecured loans to businesses as well.

What are the features of a personal loan

A personal loan is a loan taken by an individual to fund any personal expense like, for example, a wedding, to make renovations to the home or even for a vacation. There are two attractive features of a personal loan:

a. Complete flexibility of end-use. There are no restrictions on how you should spend the loan amount.  This in contrast to a home loan or auto loan where the loan amount can only be used to buy a property or a vehicle respectively.  You have the freedom to use the money in any way you want.

b. Lack of collateral. You are not required to provide any security to the lender in the form of cash, shares or any other assets.  This might make it more attractive to some customers who may not be able to raise the cash required as collateral.

What is the typical amount and loan period of a personal loan?

There is no typical loan amount and the loans can range from a few thousand rupees to several lakhs. Of course, the final loan amount that is approved depends on the lending criteria used by the bank/NBFC and how they evaluate your ability to repay the loan.

Personal loans are relatively short-term loans and the tenure can range from 1-5 years.  This is in contrast to home loans, for example, that can have a decades-long repayment period.

What are the advantages and disadvantages of a personal loan?

The advantages of a personal loan are that

i. they are relatively quick (because they do not require as much documentation as a home or auto loan)

ii. there is no restriction on how you can spend the money

iii.they do not require any collateral. If you do not have any assets like a home, or shares or gold to offer as security, and are in need of money urgently, this is perhaps the most convenient option.

Disadvantage:

The main disadvantage of a personal loan is the higher interest rate, when compared to other loans. Since the lenders do not have any security against payment default, they charge high interest rates to cover their lending risk. Personal loans can work out to be one of the most expensive loans to take in terms of interest payments.

Credit card

A credit card is an unsecured loan since you are, in effect, borrowing money from the bank to make your purchases and pay it back only at the end of the billing cycle. The bank is loaning you money, interest free, to allow you to make purchases on your credit card, without holding any collateral in case of default. If you make your payments on time and in full, you are borrowing money from your credit card issuer without offering any security and without even paying any interest on the money used.