How Is a Secured Loan Different From an Unsecured Loan?

When the need to borrow money arises, there are several choices to obtain the cash needed, including borrowing from family members, a cash advance on a credit card or a traditional loan from a bank or credit institution. Banks offer both secured and unsecured loans. It is important that borrowers understand the differences between secured loans and unsecured loans before signing any loan documentation. There are pros and cons to both types of loans.

Collateral

The main difference between a secured and unsecured loan is the collateralizing of the loan. With a secured loan, the bank will take possession of the title of the assets that are being used as collateral for the loan. This may include a home, car, investments or other assets that can be converted to cash. With an unsecured loan, there is no collateral provided for the loan. The bank does not gain access to any assets with an unsecured loan, which is generally lent on the strength of the borrower's good name and credit history.

Interest Rate

Because the bank is more at risk with an unsecured loan, the interest rates tend to be higher than with a secured loan. In some cases, the interest rates on an unsecured loan may be higher than that of your credit card. A typical unsecured loan will have a fixed interest rate. It is possible to have an unsecured line of credit, similar to a credit card, which will have a variable interest rate. Regardless, an unsecured loan’s interest rate will be higher than a secured loan where the bank has collateral to repossess if the borrower does not repay the loan.

Term

The term of an unsecured loan tends to be shorter than a secured loan. Again, this is to lessen the risk to the financial institution. Without collateral to mitigate the bank’s risk, the institution wants the money to be repaid as soon as possible. This same reasoning is also why unsecured loans are usually available in much lesser amounts than secured loans. Secured loans, particularly those secured with real estate, can have terms as long as 30 years.

Availability

Not everyone will qualify for an unsecured loan. Many banks will require an excellent credit score as well as an established relationship with the borrower before extending an unsecured loan. In fact, some banks refuse to lend money without collateral and will not even offer overdraft protection for a checking account unless it is tied to a savings account. With a secured loan, those with good credit will qualify and an existing relationship with that financial institution is usually not required.

Tax Implications

With a secured loan, it is possible to write-off the interest associated with the loan. This would hold true if the loan is secured with your primary home as collateral. However, you must also realize that you are putting your home at risk if you are unable to make the payments on the loan. With an unsecured loan, writing off the interest associated with the loan is not possible as it is not collateralized. However, you are also not risking your assets if you are unable to repay the loan.

CREDIT APPROVAL PROCESS

The approval process must reinforce the segregation of RelationshipManagement/Marketing from the approving authority. The responsibility forpreparing the Credit Application should rest with the RM within the business unit.Credit Applications should be recommended for approval by the RM team andforwarded to CRM for their review and assessment. The credit should subsequentlybe approved by proper approval committee.FIs may wish to establish various thresholds, above which, the recommendation ofthe Head of business unit is required prior to onward recommendation to CRM andsubsequent appropriate authority for approval. In addition, FIs may wish to establishregional credit centers within the approval team to handle routine approvals.

The recommended procedure for all the business units is as follows:

1.      Application forwarded to Zonal Office or Head Office for review by the ZCRO or HCRO

2.      Advise the review to recommending branches.

3.      ZCRO/HCRO supports & forwarded to Head of Business Units (HOBU) within their delegated authority and to Head of Credit Risk (HOCR) for onward recommendation

4.      HOCR advises the review to ZCRO

5.       HOCR & HOBU supports & forwarded to Credit Committee

6.      Credit Committee advises the decision as per delegated authority to HOCR & HOBU

7.       Credit Committee forwards the proposal to EC/Board for their approval within their respective authority

8.      EC/Board advises the decision to HOCR & HOBU

The approval process may vary among FI’s depending on the types of products and

exposure. For example, lending to Corporate and SME’s is mostly unstructured due to diverse nature of risk exposure. On the other hand, consumer lending is mostly structured by standardizing the product and risk aspects of individuals. As such applications for consumer lending may be done within the head of consumer unit subject to delegation of authority to do so.

CREDIT RECOVERY

The Recovery Unit (RU) of CRM should directly manage accounts with sustained deterioration (a Risk Rating of Sub Standard (6) or worse). FIs may wish to transfer EXIT accounts graded 4-5 to the RU for efficient exit based on recommendation of CRM and Corporate FI. Whenever an account is handed over from Relationship Management to RU, a Handover/Downgrade Checklist should be completed.

The RU’s primary functions are:

      Determine Account Action Plan/Recovery Strategy

      Pursue all options to maximize recovery, including placing customers into receivership or liquidation as appropriate

      Ensure adequate and timely loan loss provisions are made based on actual and expected losses

       Regular review of grade 6 or worse accounts

The management of problem facilities (NPLs) must be a dynamic process, and the associated strategy together with the adequacy of provisions must be regularly reviewed. A process should be established to share the lessons learned from the experience of credit losses in order to update the lending guidelines.

Risk Grading

The Credit Risk Grading (CRG) is a collective definition based on the pre-specified scale and reflects the underlying credit-risk for a given exposure. A Credit Risk Grading deploys a number/ alphabet/ symbol as a primary summary indicator of risks associated with a credit exposure. Credit Risk Grading is the basic module for developing a Credit Risk Management system.

Credit risk grading is an important tool for credit risk management as it helps the Financial Institutions to understand various dimensions of risk involved in different credit transactions. The aggregation of such grading across the borrowers, activities and the lines of business can provide better assessment of the quality of credit portfolio of a FI. The credit risk grading system is vital to take decisions both at the pre-sanction stage as well as post-sanction stage.

At the pre-sanction stage, credit grading helps the sanctioning authority to decide whether to lend or not to lend, what should be the lending price, what should be the extent of exposure, what should be the appropriate credit facility, what are the various facilities, what are the various risk mitigation tools to put a cap on the risk level.

At the post-sanction stage, the FI can decide about the depth of the review or renewal, frequency of review, periodicity of the grading, and other precautions to be taken. Risk grading should be assigned at the inception of lending, and updated at least annually. Fis should, however, review grading as and when adverse events occur. A separate functionFIs should generate reports on credit exposure by risk grade. Adequate trend and migration analysis should also be conducted to identify any deterioration in credit quality. FIs may establish limits for risk grades to highlight concentration in particular grading bands. It is important that the consistency and accuracy of grading is examined periodically by a function such as an independent credit review group.

Functions of Credit Risk Grading

Well-managed credit risk grading systems promote financial institution safety and soundness by facilitating informed decision-making. Grading systems measure credit risk and differentiate individual credits and groups of credits by the risk they pose. This allows FI management and examiners to monitor changes and trends in risk levels. The process also allows FI management to manage risk to optimize returns.

Use of Credit Risk Grading

􀁸 The Credit Risk Grading matrix allows application of uniform standards to credits to ensure a common standardized approach to assess the quality of individual obligor, credit portfolio of a unit, line of business, the FI as a whole.

􀁸 CRG would provide a quantitative measurement of risk which portrays the risk level of a borrower and enables quick decision making,

􀁸 As evident, the CRG outputs would be relevant for individual credit selection, wherein either a borrower or a particular exposure/facility is rated. The other decisions would be related to pricing (credit-spread) and specific features of the credit facility. These would largely constitute obligor level analysis.

􀁸 Risk grading would also be relevant for surveillance and monitoring, internal MIS and assessing the aggregate risk profile of an FI. It is also relevant for portfolio level analysis.

􀁸 CRG would provide a quantitative framework for assessing the provisioning requirement of a FI’s credit portfolio.

Risk Grading for Corporate and SME

􀁸 The proposed CRG scale is applicable for both new and existing borrowers.

􀁸 It consists of 8 categories, of which categories 1 to 5 represent various grades of acceptable credit risk and 6 to 8 represent unacceptable credit risk. However, individual FI depending on their risk appetite may implement more stringent policy.

GRADING	SHORT NAME	NUMBER
Superior	SUP	1
Good	GD	2
Acceptable	ACCPT	3
Marginal/Watchlist	MG/WL
Special Mention	SM	5
Sub standard	SS	6
Doubtful	DF	7
Bad & Loss	BL	8

Having considered the significance of credit risk grading, it becomes imperative for the financial system to carefully develop a credit risk grading model, which meets the objective outlined above.

􀁸 The following Risk Grade Matrix is provided as an example. The more conservative risk grade(higher) should be applied if there is a difference between the personal judgment and the Risk Grade Scorecard results. It is recognized that the FIs may have more orless Risk Grades, however, monitoring standards and account management must beappropriate given the assigned Risk Grade:

􀁸 The Early Alert Report (Appendix 3.3.1) should be completed in a timely manner by the RM and forwarded to CRM for approval to affect any downgrade. After approval, the report should be forwarded to Credit Administration, who is responsible to ensure the correct facility/borrower Risk Grades are updated on the system. The downgrading of an account should be done immediately when adverse information is noted, and should not be postponed until the annual review process.