Secured vs. Unsecured Loans- What's the Difference?
Secured loans and unsecured loans can both provide much-needed financing, but there are some key differences you should understand before applying for credit.
Photo by Kindel Media on Pexels
If you're thinking about borrowing money, you may come across secured and unsecured loans. While secured loans require some form of collateral, unsecured loans don't. That doesn't mean unsecured loans are always better, though.
Here's what you need to know about secured and unsecured loans and how each can impact you as the borrower.
What Is a Secured Loan?
A secured loan is a type of credit that's secured by collateral. If the borrower defaults on the debt, the lender can seize the collateral and use it to recoup the amount owed.
Some types of loans are almost always secured, while others may or may not be, depending on your credit situation. Here are some common secured loans you may come across:
- Home loans: Mortgages are virtually always secured by the property you're using the loan to purchase. Home equity loans and lines of credit are also secured by the equity you have in your home.
- Auto loans: The lender generally requires you to pledge the vehicle you're purchasing with the loan as collateral.
- Secured personal loans: Sometimes called shared-secured or savings-secured loans, these loans require that you hold a set amount of cash in an interest-bearing account as collateral for the loan. Depending on the lender, you may be able to borrow up to 100% of the collateral value or less than that.
- Secured credit card: Secured cards require that you make an upfront deposit, usually—but not always—equal to the credit limit you're seeking on the card. In most cases, you'll get the deposit back when you close the account, but some card issuers may return it before then if you use the card responsibly.
- Credit-builder loan: Designed specifically for people with bad credit, limited credit or no credit at all, credit-builder loans function a bit differently than other loans. Instead of giving you the loan proceeds upfront, they're placed in an interest-bearing account while you make monthly payments. Once you've paid off the loan in full, you'll receive the funds.
Note that there are other types of secured loans, including auto title loans, pawn shop loans and life insurance loans. But these are generally not recommended.
Pros of Secured Loans
Can qualify with a lower FICO® Score: Many secured loans are designed for people with less-than-stellar credit. If you're looking to build your credit, a secured credit card, credit-builder loan or secured personal loan can help.
Typically come with lower rates: While not always true, secured loans often charge lower interest rates than their unsecured counterparts because the lender is taking on less risk.
Larger loans: In some cases, the lender can afford to offer a larger loan amount because it's secured by collateral.
Cons of Secured Loans
Can be difficult to qualify for: In the case of a savings-secured loan or secured credit card, it may be hard to get approved if you don't have enough cash to meet the deposit requirements.
Default can be costly: It's never ideal to default on a loan. But if you default on a secured loan, you'll likely lose the asset you pledged as collateral. With larger loans like mortgages and auto loans, foreclosure or repossession can be a real setback.
What Is an Unsecured Loan?
Unsecured loans don't require collateral of any kind. So, while defaulting on the debt may damage your FICO® Scores and sometimes result in debt collection attempts, your assets won't be repossessed. Some common types of unsecured loans include:
- Personal loans
- Student loans
- Credit cards
There are other types of unsecured loans, such as payday loans, but it's best to avoid these.
Pros of Unsecured Loans
No collateral requirement: You don't have to worry about needing to come up with some cash to get approved or losing a major asset if you can't afford to repay the debt at some point in the future.
Competitive rates for strong-credit borrowers: If you have good or excellent credit, you may still be able to qualify for a relatively low interest rate on an unsecured personal loan, student loan or credit card.
Quick funding: Because there's no need to transfer money for a deposit or deal with an appraisal on a secured loan, you may be able to get access to your loan funds faster with an unsecured loan.
Cons of Unsecured Loans
Generally more expensive: While you can get a competitive interest rate if your FICO® Score is high, unsecured loans still charge higher interest rates on average than secured loans.
More limitations for borrowers with low FICO® Scores: If your credit history is considered poor or limited—or you have no credit history at all—you may face higher interest rates and fees, as well as lower loan amounts.
Risk of a lawsuit or collections: With a secured loan, the lender can simply use the collateral to recoup its losses. But with an unsecured loan, they may sell the debt to a collection agency, which may attempt to sue you to collect. While this doesn't always happen, it's important to make payments on time to avoid the possibility.
The Bottom Line
Secured and unsecured loans both have their purposes, and in some cases, you may not have a choice between the two. Even if you can choose, there are also situations where one option makes more sense than the other.
The important thing is that if you're looking to borrow money, it's crucial to understand the terms of the loan and the benefits and drawbacks of the type of loan you're choosing, and make sure you take the time to shop lenders. Take your time to consider all your borrowing options before you settle on the one that's best suited to your needs.