While secured and unsecured are alike in that you have to repay the loan over a period of time, there’s one key difference. With a secured loan, you must provide collateral (a valuable asset such as a home or car) as security in case you can't pay back your loan. Unsecured loans, on the other hand, don’t require any collateral.
Deciding which financing option will best meet your needs depends on the type of loan you're applying for, the lender's criteria, and your particular financial situation. It is important to know what you're signing up for in both instances.
What Is a Secured Loan?
With a secured loan, you, as the borrower, pledge a suitable asset as collateral. If you default on the loan, the lender can use the collateral to settle any outstanding debt. This lowers the risk of the loan from the lender's perspective.
Some of the assets you might use as collateral include:
- Property with equity: Equity is the difference between the amount you owe on your property and the market value.
- A vehicle: Either the vehicle is the purpose of the loan, such as an auto loan, or you have a freehold vehicle you're offering as security.
- Money in the bank: A savings account not pledged to another loan.
Examples of Secured Loans
Chances are you may already have a secured loan. These are some of the more well-known examples:
- Mortgage: When you apply for a mortgage, the contract details already include the provisions that allow the lender to take steps to take over the ownership of the property if you happen to default on the loan.
- Auto loan: An auto loan is similar to a mortgage in which collateral, in this case, the car, is offered by you, the borrower, as security for the loan.
- Secured credit card: A secured credit card is helpful to those looking to build or rebuild their credit scores. Typically, with a secured credit card account, you are asked to provide funds to secure repayment of the amounts you owe on the account. A lender may take as security funds in an account in your name or ask you to provide a cash deposit that is held in an account in the lender's name. The amount of the security deposit is usually the amount of your credit limit.
- Secured personal loan: A secured loan is a personal installment loan that has a collateral element. Examples include certificate of deposit (CD) loans and stock loans.
- Home equity line of credit (HELOC): A home equity line of credit uses the equity in your home as security. It differs from a mortgage as it's not used to purchase the home but instead uses the equity to secure a line of credit to fund something else — for instance, home renovations or buying a business.
What Are the Potential Advantages of a Secured Loan?
Although secured loans require collateral to be pledged as security for the loan, there may be some benefits to consider.
- More favorable loan terms: You may be better positioned to obtain a longer term or a better interest rate when you have collateral to offer.
- Higher loan amounts: The added security may allow the lender to offer higher loan amounts than with an unsecured loan.
What Are the Potential Disadvantages of Secured Finance?
Secured financing offers some benefits worth considering, but it’s also good to know what the possible pitfalls are:
- Loss of collateral: Financial situations can change, and if this affects your ability to repay the loan, you stand the chance of losing your asset. This can be particularly financially impacting if the collateral is your primary residence or car.
- Asset is tied up: If you need access to the asset, for instance, if it’s a savings account or the available equity in your home, you might not be able to access it. This is because the asset you’ve chosen as collateral is tied to that loan. Once the loan is paid off, the asset is released back to you.
- Additional application processing time: Secured financing can take longer for review as there are a few extra layers to the application. For instance, appraisers or valuers might be called to assess the asset's value.
What Is an Unsecured Loan?
An unsecured loan is a loan that doesn't require you to provide collateral.
Examples of Unsecured Loans
There are several different types to consider:
- Credit cards: A credit card is a popular unsecured line of credit.
- Personal installment loan: A non-revolving type of credit that pays the loan amount out in a lump sum. Borrowers repay the loan over a set timeline through installment payments.
- Personal line of credit: A line of credit is a product that only charges interest when you use funds from it, known as the draw. It's considered revolving credit since it allows the borrower ongoing access to the funds throughout the draw period.
- Student loans: Whether you’re applying for a federal or private student loan, these are unsecured.
What Are the Potential Advantages of Unsecured Loans?
Here are some of the possible advantages of unsecured loans:
- No collateral required: Not everyone has assets to offer as collateral. You may also prefer not to tie up your assets. In that case, unsecured financing would likely be the better option.
- Shorter application processing time: Unsecured loans generally have a quick turnaround time. In some cases, if approved, you may even receive the loan funds on the same day.
What Are the Potential Disadvantages of Unsecured Loans?
Unsecured loans might seem easy and quick to apply for, but they can have some drawbacks:
- Higher interest rates: While collateral might not guarantee better interest rates, it might put you in a better position to receive one. An unsecured loan's interest rate can depend greatly on your credit score, income, and other financial factors.
- You may not qualify based on your current financial position: If you don't have any collateral to offer, the financial institution will have to rely on other factors to determine if you are a good applicant.
- Lower loan amounts: The risk of unsecured loans is much higher, which would make lenders less eager to grant high loan amounts.
How to Choose: Secured vs. Unsecured Loans
Choosing between a secured and unsecured loan depends on your borrowing needs, the availability of a suitable asset, and lender requirements. If you're looking for a higher loan amount at a lower interest rate, offering collateral might be in your interest. If you don't want to place your assets at risk, an unsecured loan might be a good option. It's important to research and thoroughly understand the pros and cons of each option to successfully choose the loan that best meets your needs.
