All loans you may apply for can be divided into 2 categories: secured loans or unsecured loans. The difference may sound a technical one, but it affects every other aspect of the loan, your interest rate, how much you can borrow, how easy it is to qualify and most important of all, what will happen if you don’t pay.
Once you know the reason for the loan and which type you need, the way you approach the loan entirely will change.
Understanding the nature of a Secured Loan
Secured loans are backed by the assets that you own, which can be legally seized by the lender if you default on the loan. Collateral can be anything from your car, your home, or money in a savings account. In a secured loan, the lender of the loan puts a lien on the asset, an official legal claim that entitles the lender to take possession of the property if the borrower is unable to repay the loan.
Secured debt is most commonly known in the form of mortgages and auto loans. A mortgage is backed by the house. When you take out an auto loan, the car is. When the payments are missing, the lender may repossess the vehicle or foreclose on the house, and sell the property to recover the balance due.
The lender benefits from this safety net, and it invariably means that they will be able to offer a more favourable rate of interest, provide greater loans and have a more open-mindedness when it comes to applications – even by individuals with a fair or lower credit score.
Unsecured loan is simply a loan that doesn’t require collateral
In an unsecured loan, there is no collateral supporting the loan. The lender is lending because he or she believes that you’re credit worthy, that you have a good credit score, that you have an income, and that you have paid the past bills.The lender is giving you credit because he or she trusts that you are creditworthy, have a good credit score, have an income, and have paid bills in the past.
One of the reasons why credit cards have such high interest rates is they are the most common type of unsecured debt. Most student loans, including the federal, are also as unsecured as personal loans.
Lenders are risking more if they are making unsecured loans – which is what they reflect in the interest rate. That’s why an unsecured personal loan may have a bit higher interest rate than a secured loan, such as a home equity loan, and why it’s harder to secure than a secured loan. Lenders are more apt to take a closer look at your credit history and debt-to-income ratio, and if you are a safe bet, the approval process will be a bit more rigid.
Art of the possible: the Real Trade-Off between Risk and Flexibility
The primary trade-off between the two is that secured loans generally come at a better price for the terms but at the same time with the risk of an asset, making it an investment. Unsecured loans are the ones that ensure the security of your assets, but they tend to be more expensive in terms of interest and harder to obtain.
When you miss a payment on a secured loan, it’s a direct and immediate problem the lender can sell your car or start foreclosing on your house. However, in the event of defaulting on a loan that’s not secured on a specific asset, you will not lose that asset in the moment; lenders may pursue the debt through collection, and if you default on the loan, you can expect to have significant, long-lasting impacts on your credit score—and in some cases, your wages may be garnished.
Both of these are bad. The distinction is in which specific consequence you are subjected to and that’s something you want to consider well before you sign anything.
When a Secured Loan is a Good Idea
A secured loan can actually save you money if you have some assets that you don’t mind putting up as collateral and you know that you can make the payments. Lower interest rates translate to a lower total cost of the loan over time and, if your credit doesn’t qualify as high as it needs to be, having collateral can be the key to getting the loan approved or denied.
Secured loans are also helpful in cases of big purchases such as homes and vehicles, where the asset purchased is serving as the collateral. This is the normal way of doing a mortgage and auto loan.
Occasionally, an Unsecured Loan Makes Sense
An unsecured loan does not require a property to collateralize the loan, so if you don’t have an appropriate asset or don’t want to risk it, an unsecured loan does not involve your property in any way. The app application is also quicker, as there is no need to appraise or confirm ownership of the collateral.
Unsecured loans are ideal for those who need a smaller loan amount, consolidate their debt, have an unforeseen expense, or want to finance without the assurance of an underlying asset that they will repay on. The price to pay is a higher interest rate, and a stronger focus on your credit history during the approval process.
A Quick Way to Decide
It helps to ask a few simple questions before deciding which of the two to select. Do I own an asset that I really don’t mind losing if I go broke? Is the spread between the interest rates of secured and unsecured choices worth that risk? And in reality, is there any certainty of my income during the repayment period?
For those who have good collateral and income, a secured loan might actually save you real money. For those who don’t earn a steady income, or prefer to not risk any asset, the price you will have to pay for an unsecured loan could offer the extra comfort to be worth it.
The Bottom Line
Secured loans are not necessarily better or worse than unsecured loans; rather, they are useful in different scenarios. Secured loans are easier to obtain and cheaper than unsecured loans because they do not involve taking the risk of the lender seizing the assets in the event of default. Unsecured loans pay higher interest rates in exchange for none of your assets being considered. One of the first things to understand before entering into any loan agreement is what type of loan in question is and what’s involved in the event that the repayments are not being made.
Frequently Asked Questions
Are there any secured or unsecured personal loans?
The most popular type of personal loan is unsecured, which means that the loan is not backed by collateral, but instead is based on your creditworthiness and income. There are personal loan lenders that do provide secured personal loans backed by a savings account or car, which are usually offered at lower rates of interest.
What happens if I default on a secured loan?
The lender can legally seize the collateral, repossessing a vehicle or foreclosing on a home, and sell it to recover the outstanding balance. Any remaining shortfall may still be pursued as debt.
Do unsecured loans have higher interest rates than secured loans?
Generally yes. Because the lender has no asset to fall back on if you default, unsecured loans typically carry higher interest rates to offset that additional risk.
Disclaimer:
This article is for general informational purposes only and does not constitute financial advice. For guidance specific to your situation, consult a licensed financial adviser.
