When borrowing money, you will likely have to make a decision between a secured loan vs. an unsecured loan. What is the difference? Here is an explanation and a few credits counseling tips on choosing a secured loan vs. an unsecured loan.
A secured loan is a loan that is connected to a piece of collateral something valuable like a car or a home. With a secured loan, the lender can take possession of the collateral if you fail to repay the loan as agreed. A car loan and a mortgage are the most common types of secured loans.
An unsecured loan is not secured by any collateral. If you default on the loan, the lender will not be able to take your property automatically. The most common types of unsecured loans are credit cards, student loans, and personal loans.
Basically, a secured loan requires borrowers to offer collateral, while an unsecured loan does not. This difference will affect your interest rate, credit limit, and repayment terms. Both types of loans have advantages and disadvantages. So, before you decide on anything, you should understand the terms and conditions involved.
What is a Secured Loan?
Secured loans are protected by an asset. The purchased item, e.g., a house or a car can be used as security. The lender will keep the deed or title until the loan is paid in full. Other items can also be used to secure a loan. This includes stocks, bonds, or personal property.
Secured loans are the most common way to borrow large amounts of money. A lender will only borrow a large amount with a promise that it will be repaid. If you are putting your home on the line, you can make sure that you are doing everything possible to repay the loan.
Secured loans are not only suitable for new purchases. Secured loans can also be home equity loans or home equity lines of credit. These are based on the current value of your home minus the amount still owed. These loans use your home as collateral.
A secured loan means that you provide security that your loan will be repaid. The risk is that if you cannot repay a secured loan, the lender can sell your collateral to pay off the loan.
Examples of Secured Loans
- Mortgage. A mortgage is a loan to pay for a home. Your monthly mortgage payments will consist of the principal and interest, plus taxes and insurance.
- Home Equity Line of Credit. A home equity loan or line of credit (HELOC) allows you to borrow money using your home’s equity as collateral.
- Auto Loan. An auto loan is an auto financing option you can obtain through the dealer, a bank, or credit union.
- Boat Loan. A boat loan is a loan to pay for a boat. Similar to an auto loan, a boat loan involves a monthly payment and interest rate that is determined by a variety of factors.
- Recreational Vehicle Loan. A recreational vehicle loan is a loan to pay for a motor-home. It may also cover a travel trailer.
What is an Unsecured Loan?
Unsecured loans are the opposite of secured loans. This includes things like credit cards, student loans, or personal (signature) loans. Lenders take a higher risk in granting this loan because there is no asset to be recovered in the event of a default.
Because of this, the interest rates are higher. If you are rejected because of an unsecured loan, you may still be able to get secured loans. But you need to have something valuable to use as collateral.
An unsecured lender believes that you can repay the loan because of your financial resources. You will be judged based on the five C’s of credit:
- Character can include credit score, employment history, and references
- Capacity income and current debt
- Capital money in savings or investment accounts
- Collateral personal assets offered as collateral, like a home or car
- Conditions the terms of the loan
These are yardsticks used to assess a borrower’s ability to repay the debt and can include the borrower’s situation as well as general economic factors.
Note that the five C’s of credit are different for personal loans vs. business loans.
Examples of Unsecured Loans
- Credit Cards. There are different types of credit cards, but general credit cards bill once a month and charge interest if you do not pay the balance in full.
- Personal (Signature) Loans. These loans can be used for many purposes, and can vary from a few hundred to tens of thousands of dollars.
- Personal Lines of Credit. Similar to a credit card, a personal line of credit has an approved limit that you can use as needed. You can use this line of credit for almost anything, and you are only charged interest on the amount you spend.
- Student Loans. Student loans are used to pay for college and are available through both the Department of Education and private lenders. Although it is an unsecured loan, tax returns can be garnished to pay unpaid student loans.
- Some Home Improvement Loan
Secured loan vs. unsecured loan: which is right for you?
There are a few factors that play a role in choosing a secured versus an unsecured loan. A secured loan is usually easier to come by because the risk to the lender is lower. For example, if you have a bad credit history or are newly building up credit, lenders are more likely to consider you for a secured loan versus an unsecured loan.
A secured loan will also tend to have lower interest rates. That means that if you can qualify for one, a secured loan is usually a smarter money management decision than an unsecured loan. And a secured loan usually offers higher credit limits so you can get access to more money.
When you have loans and struggling to pay your bills, it is usually more important to pay back a secured loan first rather than an unsecured loan. For example, if you fail to make your car payment, you could lose your vehicle.
Remember, however, that with an unsecured loan, you will not be able to make timely payments because the interest rates on an unsecured loan can be quite high.
What to know before you take out a loan?
Before taking out any personal loan, whether secured or unsecured, make sure that you have a clear payment plan in place.
Typically, only borrow what you know you need and can payback. Make sure you are happy with the payback period. Just because you can get a loan doesn’t mean you should. So, take your time and do your research before signing on the dotted line.