The big difference between a secured loan and an unsecured loan comes down to one thing: collateral. This refers to a valuable possession, such as a house or a car, that backs up — or secures — the loan, as the lender can take that asset should you fail to repay the money you have borrowed.
While a secured loan may sound scary, and there is certainly risk involved, there are upsides to this kind of loan as compared to an unsecured loan, where you do not put anything on the line. Keep reading to better understand the pros and cons of each.
What is a secured loan?
A secured loan is a type of loan that is backed by collateral. When you take out a secured loan, “you give the lender the right to seize the asset you use as collateral should you fail to repay the loan,” said Bankrate.
Common examples of secured loans are auto loans and mortgages, wherein the property the funds are used to buy — meaning, the vehicle and the home, in these cases — is used as collateral. Because lenders can at least partly recoup their losses by seizing that property in the instance of non-payment, they view these loans as lower risk. As a result, “secured personal loans can be easier to qualify for,” and they “typically have lower annual percentage rates than unsecured loans,” said NerdWallet.
What is an unsecured loan?
With an unsecured loan, there is no property backing up the loan. Instead, “lenders rely on your credit and financial factors like your debt-to-income ratio (DTI) to assess your likelihood of repaying the loan,” and “they also use your credit score to help determine the interest rate,” said Experian. Common examples of this category of loan are personal loans, student loans and credit cards.
Since there is no collateral the lender can seize if you do not repay an unsecured loan, they typically charge higher interest rates and offer lower borrowing amounts. You will still face damage to your credit in the instance of non-payment.
Should you get a secured or unsecured loan?
Ultimately, whether a secured or unsecured loan makes more sense will depend on your intended use for the funds, your creditworthiness and the level of risk you are comfortable assuming.
For “higher-ticket purchases, a secured loan is often a better choice,” said Investopedia, as this will generally offer you better terms and a higher borrowing limit. Other reasons to get a secured loan include “locking in a lower interest rate or building your credit with a secured credit card,” as pledging collateral, assuming you have it, generally makes qualifying for a loan easier.
On the other hand, an unsecured loan presents a lower level of risk, since there is no asset on the line. Plus, unlike with a secured loan, which typically stipulates how you can use the funds, with an unsecured loan, “funds can generally be used as needed,” said Bankrate.
They are distinguished by the level of risk and the inclusion of collateral