Classification of loans
From the last unit, we got the basic ideas of loans as well as their advantages and disadvantages. Let us now learn how loans are broadly classified. They are broadly classified into three categories:
- Secured loans
- Unsecured loans
We discussed collateral in the previous chapter. A secured loan is a loan which is backed by collateral. The borrower needs to submit collateral of some kind which he/she owns. The same is kept with the bank or NBFC till the loan is repaid in full. Once the repayment is complete, the papers are released by the bank or NBFC.
The collateral can be in any form. In the case of a home loan, the house is the collateral, in the case of a car loan, the car remains as collateral. Recently, Gold loans have become very popular. In gold loans, gold jewellery or coins are taken as collateral. People can also keep their stocks, bonds, insurance policies and other investments as collateral.
From the bank’s perspective, secured loans are safer since they can sell off the collateral in case of a default in the loan. Hence, typically secured loans have lower interest rates since they are less risky to the banks or NBFC.
These are loans which are not backed by collateral. The loans are given based solely on the basis of the financial capability of the borrower. These are riskier to banks since they have to simply trust that the borrower will repay the loan. Hence, banks conduct a thorough financial analysis of the borrower to estimate their repayment capacity.
Since they entail more risks, unsecured loans have higher interest rates too. Personal loans and credit cards are the two most popular examples of unsecured loans.
Other types of loans
Sometimes banks or NBFCs take collateral on a case to case basis. Hence, they can neither be classified as a secured loan nor as an unsecured loan. Education loans, agricultural loans and business loans fall under these categories.
In the case of education loans, the loan is given to a student, who is yet to have a financial history. Hence, the financial eligibility of the parents is taken into account. Banks may or may not ask for collateral for giving out the loan. This is solely the discretion of the bank or NBFC. Hence, an education loan can sometimes be a secured loan and sometimes an unsecured loan.