While it’s often sweet to borrow money, repaying it can be a hassle. Most lenders end up losing huge amounts in the process. That's why it's important to understand the kind of loan you’re taking. The two main types of loans are Secured and Unsecured Loans. What distinguishes them? The main difference has to do with collateral: Secured loans require a collateral, while unsecured loans don’t.
This difference, however, can affect everything from your eligibility to your interest rate, the loan amount and the loan term. As you compare secured versus unsecured loans, you can use this guide to arm yourself with the knowledge you need to make the right loan choice.
What is a Secured Loan?
A secured loan is backed by a collateral provided by the borrower. A collateral is an asset — such as a house, car, land, savings account or investment account — that guarantees repayment. If you fail to repay your secured debt, the lender can seize your collateral to recover their losses.
The biggest drawback of a secured loan is that you risk losing the collateral if you’re unable to make your payments. On the other hand, these collateral-backed loans present less risk to the lender. As a result, they tend to be easier to qualify for, even if you have less-than-stellar credit. When comparing secured versus unsecured loans, you may notice that secured loans usually come with lower interest rates, larger loan amounts and longer loan terms.
Secured loans often have lower interest rates than unsecured loans, though the rate will vary by lender and loan type. You might have to choose between a fixed rate, which will be constant throughout the life of your loan, or a variable rate, which can fluctuate.
One major risk associated with secured loans is that a lender can seize your collateral if you default. If you don’t repay your auto loan, for example, a lender can repossess your car. If you fail to keep up with your mortgage, your home could go into foreclosure.
What’s more? Your credit score will suffer if you miss payments. While you’ll have some time to get your loan back into good standing before a lender seizes your assets, you might see your credit score decline right away after a single missed payment.
Where to find secured loans
You can often find secured loans at a bank, credit union or with private lenders. The lender might want to appraise your collateral before issuing the loan. Some lenders can allow you to secure a loan with a savings account or certificate of deposit.
What is an Unsecured Loan?
An unsecured loan is not secured with any form of collateral. Rather than use an asset to mitigate risk, lenders offering unsecured loans rely on creditworthiness, income and debt-to-income (DTI) ratio to determine whether you’re a good candidate for a personal loan or not.
This can make unsecured loans difficult to get if you have bad credit. For potential borrowers with good credit, unsecured loans might present a simpler application process. Unsecured loans are generally considered safer since the lender can’t seize your property as soon as you fall behind on your loan payments. However, regardless of whether you get a secured or unsecured loan, creditors can take action against you to recover their losses if you don’t pay. Debt collectors can sue you for failure to repay an unsecured debt. If granted a court order, they can garnish your paycheck or take money from your bank account.
Interest rates on unsecured loans will vary depending on the lender you choose and your credit profile. Borrowers with the strongest credit tend to get offered the lowest rates. In general, compared to secured loans, the interest rates for unsecured loans are higher since they aren’t backed by any collateral.
As with secured loans, you’ll usually pay back an unsecured loan with fixed monthly payments over a certain a certain period. You’ll also often get to choose between a fixed and variable rate. Though payments are done monthly, you can accelerate it by giving more than the monthly amount per month.
Unlike with secured loans, you don’t need to worry about a bank seizing your assets if you fall behind on an unsecured loan. However, your credit will still get damaged if you miss payments. What’s more, your unpaid debt could be sent to collections, and you could be summoned to court. So while you won’t run the risk of having your car or house repossessed, you could still face severe consequences for falling behind on an unsecured loan.
Where to find unsecured loans
There are banks, credit unions and private lenders that offer unsecured loans, though not all banks offer this financing option. Private lenders tend to offer an easy, online application and fast funding. Plus, some will even let you prequalify for offers, so you can shop around and compare your rates with no impact on your credit score.
What should you know before you take a loan?
Besides understanding the difference between secured and unsecured loans, there are a few other steps you should take before borrowing money:
First, make sure you can afford to pay back the loan. Take a look at your budget, and use a loan calculator to calculate your monthly payments and interest charges. Make sure you have a clear plan for repayment, so you don’t get stuck with debt you can’t afford — what’s more, make sure not to borrow more than you need.
Secured vs. Unsecured Loan: Which is better for you?
If you don’t have assets to provide as collateral, an unsecured loan could be your only option. But if you have fair or bad credit and an asset that could be used as collateral, a secured loan would likely be easier to qualify for. However, you’ll need to decide whether you’re willing to put that asset at risk to secure a loan.
Consider a secured loan if you … *
Have fair or bad credit
Have an asset to provide as collateral
Want the lowest interest rate possible
Want a larger loan amount or a longer loan term
Consider an unsecured loan if you …
Have good or excellent credit
Don’t have an asset to provide as collateral
Don’t need a larger loan amount
You’ll also want to think about the type of loan you want. You might be able to access more funds if you opt for a secured loan, and you might also save money by securing your loan with collateral.
Improve your credit worthiness before applying
If you prefer an unsecured loan to a secured one, you might need to improve your credit before applying. Credit is a major part of the qualification process, and it’ll also determine the interest rate you’ll get on a loan. Loans that come with high interest rates and fees can trap you in a cycle of debt. Do your best to improve your credentials as a borrower, so that you don’t get stuck with a high rate.
Repaying secured and unsecured loans
Which type of loan should you prioritize paying off first? If you’re struggling to make payments on your debts, it’s typically best to prioritize secured debt, so that you don’t lose your collateral. However, defaulting on any type of loan can have negative consequences. Thus, reach out to your lender to work out an arrangement if you’re struggling to afford your payments.
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