Unsecured versus secured loans

As name implies, a secured loan is one where you offer collateral of some kind against loan. That means, if you default on loan, lender has right (but not obligation) to take possession of asset you have pledged.

In most cases, this asset would be what lender has financed. For example, when you take a home loan, you offer home as collateral.

There may also be cases where you may need to offer additional collateral over and above asset that is being financed. This happens, for example, when lender is financing close to 100% of an asset that is prone to rapid reduction in market value. In such cases, lender may insist on your putting up another asset so as to provide a reasonable margin of protection to lender in case of default.

Unsecured loans are those where such collateral arrangements do not exist. These loans are granted based on your credit standing, ability to repay and other factors.

All other factors being equal, a secured loan may be offered at a lower interest rate as compared to an unsecured loan. That’s obviously because of lower risk associated with secured loan -- should you default, lender has an asset to fall back on. Sometimes you end up with a choice -- you can take a loan on either a secured on an unsecured basis. The difference in APRs may be quite significant in such cases. However, being offered a choice like this is comparatively rare in consumer financing, but may exist in financing businesses.

Installment versus revolving loans

A revolving loan is one where you have access to a continuous source of credit, up to a pre-determined credit limit. If limit is say, $10,000, you can borrow any amount up to $10,000. And typically, you can repay all or part of amount you borrowed at a time of your choosing, within overall tenor of loan.

However, payday loans come at exorbitant costs. This can -- and often does -- lead borrowers into a downward spiral of rapidly escalating debt. Let's look at issue from various angles to get a complete picture.

First, pluses. Here's why cash advances may hold enormous appeal for you.

You can have bad credit and still qualify for a payday loan. In most cases, no credit check is conducted. The process is fast -- it can take as little as 20 minutes to complete. Some lender even claim to target approvals in 30 seconds!

There are no upfront costs -- so buy-now-pay-later convenience applies here as well. You can apply in person at a local outlet, over phone or over Internet. You get funds deposited into your bank account in 24 hours.

Compared to some other sources for cash, payday loans are discreet -- no one else needs to know about it. The transactions are secure -- your financial information remains private.

If you're faced with an emergency -- say, unexpected medical bills -- your only consideration might be to get money now. The speed and convenience of a cash advance comes in handy here.

So what are disadvantages?

The most obvious one -- high costs. A payday loan can cost you say, $15 per two weeks. If you're borrowing only for two weeks, that doesn't sound like much. However, if you calculate Annual Percentage Rate (APR), you'll see it comes to 391%!

If you don't think that's too much, let me ask you this question. If you invested money in stock market, what would you consider a good annual rate of return? 20%? Maybe 30%? If you made a 20% return (on average) in stocks year after year, you'd be doing very well indeed. And this is for an investment that's generally considered high risk.

Now compare that with what payday loan companies charge. You are providing them with a return on their money they won't get in too many other avenues.

There is another, less obvious reason why payday loans are dangerous. According to some estimates, over 60% of borrowers roll over a payday loan. Many take loans repeatedly, too.