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 categories: secured or unsecured. To help you figure out what’s best for your financial situation, we asked experts to weigh in on the details of secured and unsecured loans, as well as the most common questions surrounding them.
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. Secured credit cards require you to put up an upfront deposit as collateral, which the credit card issuer can take to cover your bills if you don’t pay. Some personal or business loans are secured too, although they’re comparatively less common than unsecured personal and business loans. What collateral you put down depends on the loan provider. Some examples include your home furnishings (but not your house itself) or your car.
Advantages of a Secured Loan
Secured loans typically offer better rates or easier qualification, 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.
If your credit score isn’t high enough to qualify for an unsecured loan, a secured loan may be able to help you get the financing you need. However, be aware that regardless of whether your loan is secured or unsecured, the lower your credit score, the higher the interest rates you’re likely to be offered.
Examples of a Secured Loan
Some common examples of secured loans include:
- Auto loans
- Home equity loans and home equity lines of credit (HELOCs)
- Secured credit cards
- Secured personal loans backed by collateral (ex: your car)
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. And as with any debt, secured or otherwise, missing payments will cause your credit score to 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.
Another thing to be aware of, Nayar says, is that 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 will suffer as a result.
Unsecured loans may also be simpler to apply for, if not necessarily easier to qualify for. Secured loans may require an appraisal to confirm the value of the item — such as your home or car — you’re using as collateral. Unsecured loans can bypass this process.
Advantages of an Unsecured Loan
Because unsecured loans don’t require collateral, you won’t lose any of your property if you default on the loan. Be aware, though, that defaulting on a loan still has serious consequences: your credit score will take a big hit, and that negative mark could stay on your credit report for up to 7 years, according to credit bureau Experian.
Examples of an Unsecured Loan
Some common examples of unsecured loans include:
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 can also 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.
Secured vs. Unsecured Loan
To summarize, here are the main differences between a secured and unsecured loan:
|Secured Loan||Unsecured Loan|
|Backed by collateral||Not backed by collateral|
|Easier to qualify for||Harder to qualify for|
|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 among personal loans||More common among personal loans|
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.”
A “good” FICO credit score is 670 and above (out of 850), according to credit bureau Experian. 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. You can typically find your credit score — which is different from your freely-available annual credit report — through your credit card issuer or bank.
No matter what type of loan you choose, always do your research and compare rates from different lenders to find the best option for you. Depending on the lender and the type of loan you’re seeking, you may be able to pre-qualify or check your rate online without a hard credit inquiry, so you can shop around for the best deal without any ill effects on your credit score.
Does Having Collateral Improve My Chances of Getting a Loan?
Having collateral will typically improve your chances of getting a loan, especially if your credit score is poor.
But just because a secured loan is the best option for you, doesn’t mean that option will always be available. Certain types of loans are more likely than others to offer a secured option. Home equity loans and HELOCs are by their very nature secured loans. Secured credit cards are relatively common, with most of the big issuers offering at least one secured option. But most personal loans tend to be unsecured. Though you can still find secured personal loans, it might require more searching and you may be limited in your selection of lenders.
While choosing a secured loan instead of an unsecured loan may make it easier to qualify for a loan at reasonable interest rates, 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.