Secured vs Unsecured Loans: Meaning, Features, Importance, and Examples

 

Definition

A secured loan is a type of loan backed by collateral, such as property, gold, or investments, which reduces the lender’s risk. An unsecured loan does not require collateral and is issued based on the borrower’s creditworthiness, income, and repayment history.

Detailed Meaning

Loans are one of the most common financial instruments used by individuals, businesses, and governments to meet financial needs. While borrowing money, lenders assess the risk of repayment. The distinction between secured and unsecured loans lies in how this risk is managed.

• Secured Loans provide lenders with security in the form of collateral. For example, if a borrower takes a home loan, the house itself serves as collateral.

• Unsecured Loans rely on the borrower’s financial credibility. For example, personal loans or credit card loans do not require security but charge higher interest rates due to higher risk.

This classification plays a major role in financial planning, business borrowing decisions, and overall economic stability.

Sub-sections for Clarity

Secured Loans

• Backed by collateral.

• Lower interest rates.

• Larger loan amounts available.

• Risk of asset seizure if repayment defaults.

Unsecured Loans

• No collateral required.

• Higher interest rates.

• Smaller loan amounts.

• Risk to borrower’s credit score in case of default.

Formula or Calculation

Although secured vs unsecured loans don’t have a direct formula, lenders often calculate Loan-to-Value (LTV) Ratio and Debt-to-Income (DTI) Ratio to assess loan eligibility.

Loan-to-Value (LTV) Formula:

$$LTV = \frac{\text{Loan Amount}}{\text{Value of Collateral}} \times 100$$

Debt-to-Income (DTI) Formula:

$$DTI = \frac{\text{Total Monthly Debt Payments}}{\text{Gross Monthly Income}} \times 100$$

Example Calculation

Suppose a borrower applies for a car loan:

• Loan Amount = ₹8,00,000

• Car Value = ₹10,00,000

$$LTV = \frac{8,00,000}{10,00,000} \times 100 = 80\%$$

This means the loan is 80% of the car’s value.

Accounting Treatment

Journal Entry Example (For Secured Loan – Bank Loan Against Machinery)

At the time of receiving loan:

Bank A/c (Dr)        xxx  
     To Secured Loan A/c          xxx  

At the time of repayment with interest:

Secured Loan A/c (Dr)       xxx  
Interest Expense A/c (Dr)   xxx  
     To Bank A/c                       xxx  

For unsecured loans, the same entry applies, but the loan account will be classified as “Unsecured Loan.”

Detailed Illustration Calculation

Company XYZ Ltd. takes a secured loan of ₹50,00,000 against plant & machinery worth ₹70,00,000 at an interest rate of 10% per annum.

• Loan = ₹50,00,000

• Collateral = ₹70,00,000

• Interest (Yearly) = ₹50,00,000 × 10% = ₹5,00,000

Journal Entry:

Bank A/c (Dr)        50,00,000  
     To Secured Loan A/c      50,00,000  


Interest Expense A/c (Dr)     5,00,000  
Secured Loan A/c (Dr)        50,00,000  
     To Bank A/c                        55,00,000  

Key Features

Secured Loans

• Requires collateral.

• Lower risk for lenders.

• Longer repayment period.

Unsecured Loans

• No collateral.

• Higher risk for lenders.

• Quick disbursement.

Importance in Business

• Helps businesses manage working capital needs.

• Provides funding for expansion.

• Plays a crucial role in corporate finance decisions.

• Impacts balance sheet classification of liabilities.

Advantages and Disadvantages

Secured Loans

Advantages: Lower interest rates, higher amounts, longer tenure.
Disadvantages: Risk of asset loss, lengthy approval process.

Unsecured Loans

Advantages: No collateral, fast processing, flexible usage.
Disadvantages: High interest rates, strict eligibility, smaller amounts.

Usage

• Secured Loans: Home loans, car loans, business term loans.

• Unsecured Loans: Credit cards, personal loans, student loans.

Case Studies

• HDFC Bank Home Loan (India): Secured loan backed by property, offering lower rates.

• Credit Card Industry (USA): Primarily unsecured loans with high default risks, but major revenue driver.

Diagram/Table

Feature	Secured Loan	Unsecured Loan
Collateral	Required (property, assets)	Not required
Interest Rate	Low	High
Loan Amount	Higher	Lower
Risk to Borrower	Loss of collateral	Credit score damage
Approval Time	Longer	Faster

Practical Example

Ramesh applies for a personal loan of ₹5,00,000 (unsecured). Since he has no collateral, the bank charges 14% interest. Meanwhile, his brother takes a home loan of ₹25,00,000 (secured) at just 8% interest because the property is pledged as collateral.

Common Mistakes or Misunderstandings

• Believing that secured loans are always better – they can lead to asset seizure.

• Assuming unsecured loans don’t impact credit score – defaults reduce credit rating.

• Misunderstanding that all business loans are secured – many are unsecured.

Real-Life Applications & Legal Implications

• Individuals: Use secured loans for buying homes, vehicles, or starting businesses.

• Businesses: Rely on secured loans for expansion, unsecured for working capital.

• Legal Implications: In secured loans, lenders have the legal right to seize pledged assets in case of default, while unsecured loans lead to legal recovery proceedings or bankruptcy cases.

FAQs

Q1. Which is better: secured or unsecured loan?
It depends on the borrower’s need, repayment capacity, and willingness to pledge collateral.

Q2. Why are unsecured loans more expensive?
They carry higher risk for lenders, so they charge higher interest.

Q3. Can businesses take unsecured loans?
Yes, many banks provide unsecured working capital loans.

Q4. What happens if I default on a secured loan?
The lender can seize and sell the collateral asset.

Expert Tip from Learn with Manika

"Always compare your long-term financial goals before choosing between secured and unsecured loans. If you can manage collateral responsibly, secured loans save you money with lower interest rates. For short-term needs, unsecured loans may be more practical."

Related Terms

• Collateral
• Debt-to-Income Ratio (DTI)
• Loan-to-Value Ratio (LTV)
• Default Risk
• Creditworthiness