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If you’ve ever taken out a loan — a student loan, a mortgage, or a car note, for example — you have either put up an asset as collateral, or you have not.
That’s because every type of debt falls into one of two buckets: secured or unsecured. To help you figure out what’s best for your financial situation, we asked experts to weigh in on the most common questions surrounding secured and unsecured loans.
Secured vs. Unsecured Loans
A secured loan requires you to put up an asset as collateral in exchange for the loan.
For example, auto loans, taken out to pay for a vehicle, often use the vehicle itself as collateral; if you stop making payments, you may have to forfeit that car. Other examples of secured loans include mortgages, home equity loans, and home equity lines of credit (HELOC), in which your home is collateral. There are also secured credit cards, and some personal or business loans are secured too. In those cases, you might put up a sum of money as collateral.
Secured loans typically offer better rates, since the bank has some leverage in case of default.
“Because a borrower is putting collateral down, these may be easier to obtain. You may be able to get a larger loan amount at lower interest rates, and get approved with a weaker credit score,” says Anuj Nayar, financial health officer at LendingClub.
But, Nayar says, a secured loan often has a longer term, so you’ll pay it back over more time and potentially pay more interest. And the whole time, your collateral—whether it’s your car, home, or cash—will be on the line.
An unsecured loan does not require collateral. Some examples include most personal loans, student loans, and credit card balances. Because the bank has less assurance you’ll pay back the loan, unsecured loans can be harder to get, with higher interest rates and more stringent credit requirements. Defaulting on this type of loan won’t endanger a specific asset, but lenders will be able to take legal action against you, and your credit score would suffer as a result.
How Does My Credit Score Determine Which Loan I Can Get?
In general, secured loans may be easier to get if you don’t have an excellent credit score, though your risk is higher – you could lose a major asset if you fall behind on payments.
“You have to have a pretty good credit score for an unsecured loan, because there is more risk on the lender side,” says Tracy East, director of communications at Consumer Education Services, Inc, a nonprofit debt counseling firm in Raleigh, North Carolina. “If you can qualify, it may be a benefit to you, but at a higher interest rate.”
Under the FICO scale, a “good” credit score is 670 and above (out of 850). If you don’t have a strong credit score, you may not qualify for a loan or get the best terms. In that case, you may look to alternate sources of credit – but only if you’re able to pay it off responsibly. Find your credit score through your credit card issuer or bank.
“For a borrower that is having a hard time building credit history and needs access to credit without tying to an asset, I recommend looking into secured credit cards,” Nayar suggests. “A secured credit card is basically a credit card where you have paid a deposit in advance. With this type of loan, you’re able to build a credit history without racking up debt on an unsecured high-interest credit card.”
Does Having Collateral Improve My Chances of Getting a Loan?
But not all borrowers offer secured loans; for example, most personal loans are unsecured.
Offering security can make the application process easier and earn you a lower interest rate. However, Nayar cautions borrowers from overleveraging themselves: “Ask yourself if you are taking on more debt than you’re able to repay,” he says. Otherwise, your home, vehicle, or other asset could be in jeopardy.
What Are the Risks of Secured Loans?
The risk of secured loans is that you could lose an essential asset, like your house or car, if you default. Your credit score will take a hit, too.
Asset forfeiture can upend your life. You may have to leave your home because it’s been foreclosed on by the bank or rely on rides from other people because your car was repossessed. It’s best to have a bulletproof payoff plan before you put up any asset as collateral. Understand – and possibly negotiate — the terms of any agreement before you sign.
What If I Can’t Pay Back a Secured loan?
If you find yourself struggling financially, telling your lender you’ve fallen on hard times may be the last thing you want to do. But you may need to do just that.
“Keep them abreast of the situation. If you have a mortgage or car note, and your hours might have been cut, tell them what’s going on, so they don’t come for the collateral,” says Jennifer Streaks, personal finance expert and author of the book, Thrive!…Affordably.
Prioritize debt. “If you have to make a choice between a mortgage or being delinquent on a cell phone bill, you want to prioritize the bill that will safeguard your investment, if it comes down to it,” says East, of Consumer Education Services. “Have a household budget accounting for all your financial obligations. If cuts need to be made, they can be cuts to variable expenses like grocery or entertainment or clothes — things you have control over.”
What Are the Risks of Unsecured Loans?
Unsecured loans are generally considered more risky by lenders, since they do not require an asset as security. Because of this, unsecured loans typically come with higher interest rates.
Your risk as a borrower is that if you miss a payment and have to pay a penalty APR as a consequence, that penalty rate will be higher with an unsecured loan. Your lender could take legal actions against you to attempt to recoup its money.
You should strive to make all payments in full and in a timely fashion, but in the event of a missed payment, you’ll have to weigh the consequences of higher interest against the possibility of forfeiting assets if you default on a secured loan.
We’ve written extensively about loans, including mortgages and personal loans, and debt management. You can find some highlights of our past coverage below.
- Everything You Should Know Before Getting a Personal Loan
- 3 Times a Personal Loan Might Make Sense, and 3 Times It Definitely Doesn’t
- How to Get a Personal Loan
- Know Your Options Before Deciding Where to Get a Personal Loan
- Can You Get a Personal Loan With Bad Credit or No Credit, or If You’re Unemployed?
- Don’t Ever Accept Your First Loan Offer, and 5 Other Tips
- Best Personal Loan Rates for August 2020
- Getting a Mortgage Is Harder in 2020. Here’s How to Get Prepared
- Know Your Rights When It Comes to Mortgage Forbearance
- Choosing the Wrong Mortgage Lender Could Cost You Thousands. Here’s What to Look For
- How ‘Radical Saving’ and First-Time Homebuyer Programs Helped This Single Mom Buy a House
- Everything You Need to Know to Choose the Right Debt-Consolidation Strategy
- Could a Credit Counselor Help You Get Out of Debt?
- This Strategy Could Be Your Secret Weapon to Getting Out of Debt