When it comes to obtaining loans, borrowers have many different options. The options depend on the type of entity that wants to borrow.
For individuals, these options may be limited to credit card loans, private loans, or equity loans.
For businesses, there are more options available such as obtaining bank loans, trade loans, credit from suppliers, loans from directors, etc.
Borrowers have to meet some requirements set by the financial institution that is providing the loan. These requirements may include having an acceptable credit rating and source of income.
Before providing a loan, lenders put the borrower through different checks to ensure the borrower can repay the loan.
Lenders may even outright reject the application if they deem the borrower cannot repay the loan.
Another condition for providing loans may be requiring an asset to be offered as security by the borrower.
1) Secured vs Unsecured Loans
Loans are either secured or unsecured depending on whether there is a requirement for an underlying asset to be offered as collateral.
The collateral of a loan is the deciding factor of whether the lender will obtain the loan or not and what the terms of the loan are going to be.
2) Secured Loans
Secured loans are loans that are offered in exchange of an asset offered as security. Secured loans have many advantages for both borrowers and lenders of the loan.
For borrowers, secured loans are easier to obtain because the risks associated with the loan are lower for lenders as compared to other loans.
Since the risks are lower for the lenders, the interest rates of the loan are also lower than interest rates of unsecured loans.
For lenders, the underlying asset offered as security reduces the risk of the loan significantly.
When an asset is offered as collateral in a loan, it means that in case the borrower of the loan fails to pay the loan, the lender has the legal right to the asset.
This means that whether the buyer repays the loan or not, the lender will always be compensated for their loan.
3) Unsecured Loans
Unsecured loans are loans where no assets are provided as collateral. The risks in unsecured loans are higher for the lenders of the loan.
Unsecured loans are beneficial to the borrowers as they allow borrowers to obtain a loan without having an asset to offer as collateral.
This can be advantageous to borrowers that do not have any assets to offer or do not want to risk losing their assets. However, the interest rates on unsecured loans are significantly higher for the borrowers.
On the other hand, unsecured loans are more disadvantageous to lenders as compared to secured loans.
This is because in case the borrower of the loan fails to repay the loan, the lender has to file a legal action against the borrower.
The recoverability of the loan will depend on the result of the legal action. Lenders compensate for the higher risks of an unsecured loan by increasing the required interest rates significantly.
This allows lenders to make more return on the risk they are taking. Lenders also have stricter requirements for the approval of borrowers in case of unsecured loans.
4) Equity Loans
Equity loans are secured loans provided on assets with equity. The most popular form of equity loans are home equity loans that are provided to borrowers that offer their homes as collateral.
Equity loans have all the advantages of secured loans. They come with lower approval requirements and lower interest rates for buyers while having a low risk for lenders.
However, in case of failure to repay the loan, borrowers risk losing their assets, which is provided as security.
What is Equity in Assets?
All assets have a fair value but that is not the amount of equity in the asset. The amount of equity in an asset is equal to the fair value of the assets minus any pending amounts payable on the asset.
Usually, equity loans are provided by calculating the amount of equity in an asset. Lenders use ratios, such as the Loan To Value ratio, to calculate the amount of loan that they can provide to the borrowers.
These ratios use the equity of the assets, being provided as collateral, to calculate the amount.
For example, the fair value of an asset provided as security is $300,000 and the pending amounts payable on the asset are $200,000. The lender providing the loan wants to maintain an LTV ratio of 80%.
To calculate the amount of home equity loan that will be provided, the LTV ratio is multiplied with the fair value of the home, thus, getting $240,000 ($300,000 x 80%).
Subsequently, the pending amounts payable are reduced from the amount to determine the amount of loan that will be provided, which is, $40,000 ($240,000 – $200,000).
Types of Equity Loans
The most popular type of equity loan is home equity loan. Home equity loan is the type of equity loan where a home, owned by a borrower, is offered as a collateral for the loan.
The loan is provided on homes that have a fair market value that exceeds any pending amount payables on the home.
Home equity loans are easier to obtain for homeowners as compared to other types of loans. These loans are provided to homeowners for a period of 5 to 15 years.
Another type of equity loan that has recently become popular is the government equity loans. In this type of loan, instead of financial institutions lending money, the government helps the borrowers with the loan instead.
Government Equity Loan
Government equity loan schemes are also known as help to buy schemes. In a government equity loan, the government helps first time home buyers to buy a newly built home.
Under this scheme, the individual that wants to buy the home is required to offer at least 5% of the home’s value as a deposit. The government then pays between 20% to 40% of the home’s value.
Both of the deposits, by home buyer and government, are added up to fatten the deposit on the home.
The remaining value of the home is covered by applying for a mortgage.
For example, a buyer obtains a 20% government equity loan to buy a newly built home.
The buyer is contributing a deposit of 5%. This means that 75% (100% – 5% – 20%) of the home value will be covered by the mortgage.
Government equity loans are different to home equity loans. Home equity loans are obtained on an already bought home while government equity loans are given before a home is bought.
This means that the borrower does not have to already own an asset to offer as security.
However, once the home is bought, the government owns part of the home up to the portion of the loan provided by the government. This means that if the government pays 20% of the deposit of the home, the government owns 20% of the home.
The government equity loan scheme is only available to first time home buyers. Borrowers who already own a home or have owned a home in the past are not eligible for this scheme.
Furthermore, the loan is only given out for newly built homes and not secondhand homes.
Borrowers who want to obtain the government equity must also use the home, that is being bought, themselves, and not rent or sublet the home.
The government will have limits on the maximum amount of home value that will be eligible for the government equity loan.
For example, in the United Kingdom, the limit for the value of the home for which the government can provide the loan is £600,000.
If a buyer wants to buy a home that is worth more than this amount, the buyer will not be eligible for the loan.
The government also decides the percentage of the deposit it provides in a government equity loan. Usually, the rate is set at 20% but the government may choose to increase it to up to 40%.
The fees payments on government equity loan are more lenient than other types of loans. Borrowers do not have to pay any fees within the first 5 years of the loan.
In the 6th year of the loan, the fees payments begin at a pre-determined rate. This rate is generally lower as compared to rates on other types of loans.
The rates increase every year after the 6th year according to the changes in Regional Price Index plus a fixed 1%.
Government equity loans are given for up to 25 years. Borrowers have to pay the government equity loan in 25 years or even earlier if the home is sold before that.
Borrowers can also choose to repay the loan fully before the end of 25 years if they wish to. However, the principal amount of repayment is not the same as the initial amount that the government loaned.
The amount of repayment depends on the fair market value of the home at the time of repayment.
For example, an individual wants to buy a home worth $300,000 in the market and obtains a 20% home equity loan.
This means the amount of loan provided by the government is $60,000 ($300,000 x 20%). Assuming at the time of repayment, the home is worth $400,000, the individual will not repay $60,000 that was the original value of the loan but will repay $80,000.
This is because the home is worth $400,000 at the time of repayment and the initial percentage of deposit by the government was 20%. Thus, the repayment amount will be $80,000 ($400,000 x 20%).
Borrowers have many options when it comes to obtaining loans. These loans can either be secured or unsecured depending on whether the loan requires an asset to be offered as collateral.
Equity loans are a type of secured loan. For individuals looking to buy a newly built home, a government equity loan is an option.
In this loan, the government covers between 20% and 40% of the initial deposit for the home. This loan is then repaid in 25 years. The fees for the loan begin after the 5th year of the loan.