The Difference Between Secured and Unsecured Loan
If you’re in the market for a consumer loan, you may have the option of choosing between what’s known as a secured loan and an unsecured loan. Both types of loans will give you access to funds that you will need to pay back at a later date, but they come with clear differences that every borrower should be aware of. Learn more about the difference between secured and unsecured loans so that you can find the right type of loan for your needs.
What are Secured Loans?
Secured loans are secured by a tangible asset or good. The lender will use your house, car or item of value as collateral in case you default on the loan. This act reduces the amount of risk the lender takes on when issuing the loan.
For example, if you borrow money to buy a home, the lender will place a lien on your property until you pay off the loan in full. Once the loan has been repaid, you will own your home outright. If you default on your mortgage and cannot repay the loan, the lender will repossess your home to recoup its investment. The same is true of your car if you have an auto loan. A repossession will stay on your credit report for around seven years. After the lender has repossessed the item being used as collateral, you will usually be absolved of your debt.
You don’t always have to use your car or home as collateral when taking out a secured loan. In some cases, you can use another tangible asset as collateral, such as your life insurance policy, stocks, bonds, bank accounts, money market accounts, as well as some collectibles and antiques. Lenders use collateral to protect themselves from financial ruin if you were to default on your loan. That’s why you don’t own your home or car until you have paid off the loan you used to purchase it.
Secured loans include:
- Car loans.
- Share-secured or savings-secured loans.
- Secured credit cards.
- Home equity loans and lines of credit.
- Secured line of credit.
- Car title loans.
- Pawnshop loans.
- Life insurance loans.
What are Unsecured Loans?
In contrast, unsecured loans are not secured by physical assets, such as valuables, money, a home or cars. The lender has few options if you were to default on your loan. They cannot repossess your assets in this situation, which means they are taking on more risk.
To make up for this added risk, the lender will typically charge more in interest to make sure the company recoups its investment. You also can’t rely on having the lender repossess your valuables if you default on the loan. That means the debt may follow you around until it is settled, paid, or you declare bankruptcy.
Unsecured loans are growing in popularity. Americans are using unsecured loans to consolidate their debt and make large purchases even though they don’t have a home, car, or other assets to use as collateral. They are popular because you can use a consumer loan like personal loans for just about anything. However, these loans can pose a risk to your finances if you have trouble paying them back.
Unsecured loans include:
- Personal loans.
- Personal lines of credit.
- Student loans.
- Unsecured credit cards.
Most credit cards are not secure, which is why they often have double-digit interest rates. A secured credit card usually has a lower interest rate than an unsecured credit card. The credit limit of the card is secured against the initial deposit you pay when you open the card.
Choosing Between Secured vs Unsecured Loans
There are several factors to consider when choosing between a secured and unsecured loan. Keep these variables in mind when evaluating your options:
With no collateral, unsecured loans often come with high interest rates that can make it harder to get out of debt. Consider going with a secured loan, if possible, to save money in interest payments down the line. Some credit cards come with interest-free introductory periods, which means your debt won’t accrue interest during this time. Try to pay off the principal as much as possible before this period expires.
Your Credit Score
Lenders of both secured and unsecured loans will need to evaluate your financial background before approving your application, including your credit score, debt-to-income ratio, and current income.
However, lenders will give these factors more weight if you are applying for an unsecured loan. Without collateral, they will need to evaluate your ability to repay the loan on time to minimize their risk.
If you have a poor credit score or a high debt-to-income ratio, you may not get approved for an unsecured loan or get a higher interest rate. If possible, consider holding off on applying until your finances are in a better position or pursue a secured loan if it would give you more favorable terms.
Come Up with a Plan
Compare the terms and conditions of different loans to see how they will affect your budget. If you can choose between a secured and unsecured loan, it’s often better to go with a secured loan. They tend to have lower interest rates than unsecured loans and the terms tend to be more favorable. Secured loans usually come with more repayment options to help you make ends meet if you are having trouble making your monthly payment.
Regardless of what type of loan you choose, make sure you can pay it back on time to avoid damaging your credit score.
Add up the total cost of the loan, including origination fees, closing costs and loan maintenance fees to make sure you can afford it. Calculate your regular monthly payment before applying to see if it fits into your budget. There are many different types of loan calculators also available to help make these decisions.
You should only borrow what you need. Just because you can get approved for a loan, doesn’t mean you should. Manage debt by reigning in your living expenses and putting any additional savings toward paying off high-interest debt. Loans should help you build your credit score and reach your financial goals in life, not make it harder for you to pay your bills.