A secured loan is one in which the creditor pledges an asset (such as a house or a vehicle) as collateral to secure the loan.
It is referred to as a secured loan because it poses less risk to financial institutions; for instance, if the borrower defaults on payments, the creditor can repossess the collateral to satisfy the debt. Secured short-term personal loans are an excellent method to obtain cash quickly.
A loan may also be considered secured to the extent that it is backed by a third-party financial guarantee or surety arrangement if the credit enhancement provider is deemed to be of high credit quality.
Examples of commonly used collateral in secured loans include real estate, vehicles, inventory, or equipment. By offering collateral, borrowers give lenders confidence that they have a fallback option should the borrower fail to repay the loan as agreed.
Unsecured loans refer to money borrowed without the security of collateral to support the loan. Anyone receiving an unsecured loan must agree to the terms and interest rates for repaying the loan. By signing a document, the creditor swears to pay back the borrowed amount.
Examples of unsecured loans commonly offered include personal loans, credit card loans, and lines of credit. Lenders typically assess the creditworthiness of borrowers by reviewing their credit history, income, and other financial factors before approving unsecured loans.
Comparison between Secured and Unsecured Loans
When it comes to interest rates, secured loans generally have lower interest rates compared to unsecured loans. This is because lenders view the presence of collateral as a form of risk mitigation, allowing them to offer more favourable interest rates.
Securing a loan also affects the approval process. Secured loans typically have a more straightforward approval process since lenders have the collateral as security. In contrast, unsecured loans may require more documentation and a more rigorous evaluation process to determine the borrower’s creditworthiness.
In terms of risk, secured loans are generally considered less risky for lenders since they have collateral as a form of repayment assurance. Conversely, unsecured loans are riskier for lenders since they have no specific assets to claim in case of default.
Loan amounts and terms also differ between secured and unsecured loans. Secured loans often have higher borrowing limits and longer repayment terms compared to unsecured loans. This is because lenders are willing to extend more credit and have greater flexibility when there is collateral involved.
Accounting Treatment of Secured and Unsecured Loans
From an accounting standpoint, the distinction between secured and unsecured loans is crucial. Let’s explore how these loans are treated in accounting:
When recording secured loans in the balance sheet, both the liability (loan amount) and the corresponding collateral (asset) are recognized. This reflects the presence of an obligation and the safeguarding of the loan with collateral. The collateral is typically classified as an asset and evaluated for impairment or changes in value over time.
Unsecured loans, on the other hand, are recorded differently. Only the liability (loan amount) is recognized in the balance sheet, as there is no collateral to accompany the loan. The inherent risk associated with unsecured loans is typically disclosed in the financial statements to provide transparency to potential investors or creditors.