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- A “secured” loan is a type of financing that requires some kind of collateral — such as your home, automobile, or other asset — to obtain the loan.
- An “unsecured” loan does not require any form of collateral to qualify for financing. Instead, all that’s needed is your signature, in most cases.
- Most secured loans charge lower interest rates, since they are less risky for the lender. Unsecured loans may tack on higher rates, however, because there’s no easy way for the lender to recover its losses if you fall behind on payments.
Loans typically come in two varieties: secured or unsecured. A secured loan requires collateral, while an unsecured loan does not require collateral. But there are other important differences between these two types of loans.
Take the time to learn more about secured loans compared to unsecured loans, the interest rates charged for each, lender requirements (including credit scores needed), and how to get approved.
What is a secured loan?
A secured loan is a type of financing that requires some kind of collateral (such as your home, automobile, or other asset) to obtain the loan. If you fail to repay a secured loan, the lender can seize the asset that was pledged as collateral.
How does a secured loan work?
The lender will put a lien on your collateral if you are approved for a secured loan, explains Lyle Solomon, a principal attorney at Oak View Law Group and a consumer-finance expert. “This [lien] allows the lender to keep the collateral if you fail to repay. The value of the collateral should be more than or equal to the amount owed,” he says.
In exchange for requiring you to provide collateral, a secured-loan lender typically offers a lower fixed interest rate than you would get with an unsecured loan.
Types of secured loans
There are many different examples of secured loans, including:
- Mortgage loans to pay for a home purchase or refinance
- Home equity loans, which tap into your home’s accrued equity
- A home equity line of credit (HELOC), which also borrows against your home’s accrued equity
- Auto loans used to purchase a new or used vehicle
- Secured credit cards
- Secured personal loans
What is an unsecured loan?
An unsecured loan does not require any form of collateral to qualify for financing. Instead, all that’s needed is your signature, in most cases.
How does an unsecured loan work?
The good news about unsecured loans is that your assets cannot be seized by the lender if you fail to repay the loan, as no collateral is required.
“The lender might decide to bear the financial loss or pursue repayment of the debt through a court judgment,” Solomon of Oak View Law Group notes. “But because this type of loan is riskier than a secured loan, the lender may charge a higher interest rate and require you to have a good or excellent credit score before approving the loan.”
Types of unsecured loans
Examples of unsecured loans include:
- Personal (signature) loans
- Personal lines of credit
- Student loans
- Credit cards
Ways that secured and unsecured loans are different
Unsecured and secured loans have significant differences. To make a more informed decision about which type of loan to pursue, it’s important to understand these distinctions.
The biggest difference between an unsecured loan and a secured loan is that the latter obligates you to put up some form of collateral, as mentioned. The types of collateral you may be allowed to use include your home or other real estate, automobile, investments, cash accounts, collectibles, jewelry, valuables, and insurance policies.
Most secured loans charge lower interest rates, since such loans are less risky for the lender. Unsecured loans may tack on higher rates, however, because there’s no easy way for the lender to recover its losses if you fall behind on payments.
Because there is collateral involved in the case of a secured loan, “the amount you can borrow is usually higher than for an unsecured loan,” adds Solomon.
How you can use the money
For both types of loans, you can usually use the funds for any purpose you want, so long as it is legal, doesn’t involve gambling, or isn’t used to purchase investments. Still, secured loans may occasionally have more spending restrictions than unsecured loans, according to Solomon.
“When it comes to a secured loan, lenders usually sanction this loan for specific reasons – like purchasing a boat, a vehicle, a home, or an RV. In other words, with a secured loan you may have less freedom to use the funds,” he says.
Requirements to qualify
You may need better credit – including a higher credit score – for an unsecured loan. “The minimum requirements for many unsecured loans is a credit score of at least 670, steady monthly income, and a strong job history,” says Dennis Shirshikov, a strategist at Awning.com and a professor of economics and finance at City University of New York. An unsecured loan lender may also have a certain debt-to-income (DTI) ratio ceiling, such as 36% to 50%, that you cannot exceed.
For secured loans, a credit score of at least 620 is usually needed. The lender may also require you to furnish proof of sufficient income and employment history.
Which is better for you?
Any large purchase that can be used as collateral should probably be made using a secured loan, advises Shirshikov of the City University of New York . (Large purchases would include homes, equipment, cars, and other assets.)
“Any small purchases or financial stopgaps like debt consolidation should be done with unsecured loans to avoid risking additional assets if it’s not needed,” he adds. “The exception here is that large borrowing amounts should be done using a secured loan like a home equity loan or home equity line of credit to reduce the interest rate on the borrowed amount.”
Good candidates for a secured loan are borrowers with poorer credit, with an asset to use as collateral, who desire the lowest possible interest rate, and who seek a larger loan amount or longer loan term.
“However, before signing the papers, you should consider whether a secured loan is worth the risk,” Solomon of Oak View Law Group cautions. “You are not a good candidate for a secured loan if you have doubts about using your valuable assets as a security or aren’t sure you can pay back the loan in time.”
Jake Hill, CEO of DebtHammer, an advisory, says worthy prospects for an unsecured loan are individuals “who can create a budget to adhere to the loan but are only capable of paying it off over a long period. Those who have the financial stability to pay off the loan in a more timely manner should probably choose a secured loan if they qualify.”
Many banks, credit unions, online lenders, and other financial institutions offer secured and unsecured loans.
Is a mortgage secured or unsecured?
A mortgage loan is an example of a secured loan. That’s because you are required to put up collateral (the home itself) to obtain this financing. It’s usually not possible to purchase or refinance a mortgage using an unsecured loan.
Why is a secured loan less costly than an unsecured loan?
A secured loan often charges a lower interest rate and possibly lower financing fees overall than an unsecured loan because the former is less of a risk for the lender. Because you are pledging assets (like a home, car, or cash account) as collateral, the lender is usually willing to charge less for a secured loan.
Do you need collateral for a personal loan?
A standard personal loan does not require collateral. Instead, your signature is typically needed to secure the loan. Hence, personal-signature loans are easier to obtain; but they also may charge a higher interest rate, have lower borrowing limits, and require a higher credit score than does a secured loan.