If you’re looking to take out a personal loan, you’ll likely choose between two different types: secured loans and unsecured loans. Both will get you money to pay off your debt or to make a large purchase. But secured loans and unsecured loans are much different. A secured personal loan requires a borrower to offer collateral (something of value) to the lender–this can include the rights to their home or car. This collateral protects the lender in case the debt can’t be paid off. An unsecured loan does not require collateral. Let’s look at each type.
What are secured loans?
Secured loans are personal loans that require the borrower to offer something of value to the bank or lender in exchange. Secured personal loans are usually large amounts of money used to buy a home, car, or land. A secured loan helps borrowers because it usually has a lower interest rate, more time to pay off the loan, and larger amounts of money. But lenders prefer secured loans to help cover them if the borrower can’t pay the loan back.
Examples of secured loans
Secured loans are a very common way for people to borrow large sums of money. Some examples include:
- Mortgage. Mortgage loans are used to purchase a home. With a mortgage loan, you’re using your property or home as collateral. If you don’t make your payments on time, the bank can take your home and sell it.
- Auto, boat, or RV loan. This works the same way as a mortgage loan. When you take out a secured loan to buy a vehicle (a car, truck, boat, or recreational vehicle), the vehicle is used as collateral and can be taken away if you don’t pay off the loan.
- Home equity line of credit. A home equity line of credit lets you borrow money from your home’s value (equity). Your home also serves as collateral for a home equity line of credit.
- Business loan. You can take out a business loan to pay for business expenses, such as equipment and employee paychecks. Many people offer equipment, a business’s building, or land as collateral. Any of these can be taken by the lender if the loan is not paid off.
- Land loan. If you need money to purchase land, this loan is useful. The land itself is the collateral.
Advantages of secured loans
For borrowers, secured loans offer some potential advantages.
- Easy to qualify for. Because a borrower must offer collateral in exchange for a lender’s money, it’s easier for a borrower to take out a secured loan because the lender is protected.
- Lower interest rates. Collateral protects the lender, so they can afford to offer lower interest rates on the loan. This can save you a lot of money.
- You can borrow more money. Most secured loans have higher borrowing limits than unsecured loans. This means you can borrow much more money for larger purchases.
Disadvantages of secured loans
While there are many reasons why borrowers want a secured personal loan, there are a few things to remember:
- Collateral can be taken. It’s important to pay off your loan, or else whatever you offered as collateral can be legally taken from you by the lender. This could be your house, land, your car–whatever you offered in exchange for the loan.
- Loan can only be used for specific purchases. Many secured loans can only be spent on one thing. For example, if you take out a mortgage loan, you can’t use that money for a vacation–you must put that money toward the purchase of a home. Same with a vehicle loan–you can only use that money to buy a vehicle.
- Possible credit damage. A good credit score is important when it’s time to make a big purchase or take out a loan. Not paying off your secured loan can damage your credit and make you less likely to be approved for future loans.
What are unsecured loans?
An unsecured loan does not require collateral. You just need to meet a lender’s borrowing requirements. Not having to offer collateral is the main reason why some people prefer unsecured loans. Another reason is that, when you take out an unsecured personal loan, you can use the money for just about anything–unlike a secured loan.
Examples of unsecured loans
Unsecured loans are very common, and you’re likely to recognize many of these types of loans below:
- Personal (signature) loans. A personal loan can be just about any amount of money you need, from a couple hundred dollars to thousands. And you can use this money to purchase whatever you want.
- Credit cards. The credit card company provides you with the ability to purchase items with the card, with the understanding that you will pay back your debts each month (plus interest, if the entire balance is not paid off).
- Student loans. With college costs always rising, most students need to borrow money to pay for their education. A student loan provides students and families with money to be spent on college tuition and is expected to be paid back later, with interest.
- Personal line of credit. This is very similar to a credit card. A personal line of credit allows you to borrow money, up to an approved amount, to spend on whatever you wish. You are only charged interest on the amount of money you spend.
- Home improvement loans. Home repairs and improvements are costly. Many people take out unsecured home improvement loans (which are different from a home equity line of credit) to pay for these expenses.
Advantages of unsecured loans
Unsecured loans are popular among borrowers for a few reasons:
- No collateral needed. Many borrowers feel more comfortable with unsecured personal loans because there is no risk of their home, vehicle, or something else valuable being taken away if they don’t pay back their loan.
- Smaller borrowing amounts. Since an unsecured loan will not be used to purchase a home or a car, it may be a better option for smaller purchases.
- Faster processing time. Most unsecured loans can be paid to the borrower faster than a secured loan because there is no collateral involved.
Disadvantages of unsecured loans
While unsecured loans remove the risk of having your collateral taken away, there are a few negatives involved with taking out an unsecured personal loan:
- Higher interest rates. Without collateral, lenders need a way to protect themselves if the borrower can’t pay off their debt. So they may charge higher interest rates to get more money from the borrower each month as the loan is paid off.
- Credit history is necessary. Again, because the bank or lender isn’t protected by collateral, they want to make sure the borrower has a credit history so they know the loan will be paid off. If you don’t have a good credit history or credit score, you may not qualify for an unsecured loan.
- Risk of damaging credit history. If you have a good credit history and are able to take out an unsecured personal loan, just be sure to pay off the debt completely. If you can’t pay the loan off, it can cause a lot of damage to your credit score and history.
What are key differences between secured and unsecured loans?
Having assets as collateral
A secured loan requires borrowers to offer collateral in exchange for money. This could be a home, a vehicle, or another valuable asset. Not repaying a secured loan leaves borrowers at risk of losing any of these. An unsecured loan, on the other hand, does not require collateral.
Requirement difficulty
Because no collateral is required for an unsecured loan, it’s more difficult to get approved. To take out an unsecured personal loan, you need credit history and income to show ability and willingness to repay the loan. Taking out a secured loan is easier because there is less risk for the lender. If you don’t pay your secured loan, they can take your collateral to recover their lost money.
Limit on borrowing amount
If you need a large amount of money to put toward a house or a car, a secured loan is likely the right option. Secured loans, because of the collateral the borrower must provide, can offer much higher borrowing limits than an unsecured loan.
Ways the money can be used
Secured loans can usually only be used for a single large purchase, such as a house or a vehicle. An unsecured loan can be used on just about anything (except for gambling or purchasing stocks, bonds, etc.).
Interest rates
Lenders take on less risk with secured loans, because they know they can take the borrower’s house, vehicle, or other asset if the borrower can’t pay back the debt. And because lenders are more protected financially with secured loans, they are able to offer borrowers lower interest rates.
On the other hand, unsecured loans are much more risky for lenders because there is no collateral to take from the borrower if the loan goes unpaid. That’s why unsecured loans tend to have higher interest rates–so the lender is safer financially if a borrower is unable to make payments on the debt. Even with unsecured loans, however, you may still be eligible for lower interest rates if you have a good credit history.
Choose the best loan option for you
Secured and unsecured personal loans offer borrowers different ways to get the money they need. Secured loans, which require collateral from the borrower, are ideal for expensive purchases like a home, car, RV, or land. Unsecured loans, with no collateral needed, are great for smaller purchases or expenses, no matter what they are.
