If you’ve ever taken out a loan – such as a student loan, mortgage, or car letter – you either have an asset on deposit or not.
That’s because any type of debt falls into one of two categories: secured or unsecured. To help you figure out what is best for your financial situation, we asked experts to weigh the details of secured and unsecured loans and the most common questions about the topic.
A secured loan requires you to deposit an asset as collateral in return for the loan.
For example, car loans taken out to pay for a vehicle often use the vehicle itself as collateral; If you stop paying you may need to withhold this car. Other examples of secured loans include mortgages, home equity loans, and home equity lines (HELOC) where your home is used as collateral. With secured credit cards, you must make a prepayment as security, which the credit card issuer can ask to clear your bills if you fail to pay. Some personal or business loans are also secured, although they are comparatively less common than unsecured personal and business loans. What collateral you deposit depends on the lender. Some examples are your home furnishings (but not your house itself) or your car.
Benefits of a secured loan
Secured loans usually offer better interest rates or an easier qualification because the bank has some leverage in the event of a default.
“Since a borrower is posting collateral, it may be easier to obtain. You may be able to get a larger loan amount at lower interest rates and be approved with a weaker credit rating, ”says Anuj Nayar, financial health officer at LendingClub.
If your credit rating is not high enough to qualify for an unsecured loan, a secured loan can potentially help you get the financing you need. Note, however, that regardless of whether your loan is secured or unsecured, the lower your creditworthiness, the higher the interest rates you are likely to be offered.
Examples of a secured loan
Some common examples of secured loans are:
- Car loans
- Home Equity Loans and Home Equity Lines of Credit (HELOCs)
- Secured credit cards
- Secured personal loans with collateral (e.g. your car)
What are the Risks of Secured Loans?
The risk of secured loans is that if you default, you could lose a significant asset such as your home or car. And, as with any debt, secured or otherwise, missed payments can also cause your creditworthiness to suffer.
Wealth deterioration can turn your life upside down. You may have to leave your home because the bank has foreclosed it or you may need someone else to give you lifts because your car has been repossessed. It is best to have a bulletproof withdrawal plan in place before depositing any asset as collateral. Understand – and possibly negotiate – the terms of an agreement before signing it.
Another thing to be aware of, says Nayar, is that a secured loan often has a longer term, so over a longer period of time you will pay it back and potentially pay more interest. And all the while, your collateral – whether it’s your car, house, or cash – is at stake.
An unsecured loan does not require any collateral. Some examples are most personal loans, student loans, and credit card balances. Since the bank is less certain that you will pay back the loan, unsecured loans with higher interest rates and stricter credit requirements can be more difficult to obtain. A default on this type of loan does not put any particular asset at risk, but lenders can take legal action against you and your creditworthiness will suffer.
Unsecured loans can also be easier to apply for, though not necessarily easier to qualify for. Secured loans may require an assessment to confirm the value of the item you use as collateral – your home or car, for example. Unsecured loans can bypass this process.
Benefits of an Unsecured Loan
Since no collateral is required for unsecured loans, if you default on the loan, you will not lose any property. Be aware, however, that defaulting a loan still has dire consequences: your creditworthiness will take a major hit, and that negative mark could stay on your credit report for up to 7 years, according to the Experian credit bureau.
Examples of an unsecured loan
Some common examples of unsecured loans are:
- Student Loans
- Unsecured personal loans
- Unsecured credit cards
What are the Risks of Unsecured Loans?
Unsecured loans are generally considered riskier by lenders because they do not require an asset as collateral. Because of this, unsecured loans are usually associated with higher interest rates.
Your risk as a borrower is that if you miss a payment and have to pay an APR as a result, that penalty rate will be higher on an unsecured loan. Your lender can also take legal action against you in an attempt to get their money back.
You should strive to make all payments in full and on time, but if you fail to pay, you must weigh the consequences of higher interest rates against the possibility of financial loss if you default on a secured loan.
Secured vs. Unsecured Loan
In summary, here are the main differences between a secured and an unsecured loan:
|Secured Loan||Unsecured Loan|
|Secured by collateral||Not covered by collateral|
|Easier to qualify||Harder to qualify|
|Potentially lower interest rate||Potentially higher interest rate|
|More risky for the borrower, less risky for the lender||More risky for the lender, less risky for the borrower|
|Less common with personal loans||More common with personal loans|
How does my credit score determine which loan I can get?
In general, secured loans can be easier to come by if you don’t have excellent credit, although your risk is higher – you could lose a large asset if you default on payments.
“An unsecured loan requires a pretty good credit rating because the lender is more at risk,” said Tracy East, director of communications at Consumer Education Services, Inc, a nonprofit debt counseling firm in Raleigh, North Carolina. “If you can qualify, you may benefit from it, but at a higher interest rate.”
According to the Experian credit bureau, a “good” FICO credit score is 670 and more (out of 850). If you don’t have a good credit score, you may not be able to qualify for a loan or get the best terms and conditions. In that case, you can look to alternative sources of credit – but only if you are able to pay them off responsibly. You can usually find out your creditworthiness – which differs from your freely available annual credit report – through your credit card issuer or your bank.
Whichever type of loan you choose, always do your research and compare the rates of different lenders to find the best option for you. Depending on the lender and the type of loan you are looking for, you may be able to pre-qualify or verify your interest rate online without a tough loan application, so you can browse the best deal with no negative impact on your credit score.
Will collateral improve my chances of getting a loan?
Collateral usually increases your chances of getting a loan, especially if your credit rating is poor.
But just because a secured loan is the best option for you doesn’t mean that option is always available. Certain types of loans offer a secured option more than others. Home loans and HELOCs are inherently secured loans. Secured credit cards are fairly common, with most major issuers offering at least one secured option. But most personal loans are usually unsecured. While you can still find secured personal loans, you may find that you have to search harder and you are limited in your choice of lenders.
While choosing a secured loan over an unsecured one can make it easier to qualify for a decent interest loan, Nayar cautions borrowers not to go into debt: “Ask yourself if you are taking on more debt than you can repay .” he says. Otherwise, your home, vehicle, or other asset could be at risk.