Secured vs Unsecured Loan: What’s the Difference?
Secured loans are those that require some type of collateral to qualify, and because of this collateral, they pose less risk to a lender. Unsecured loans have a higher risk to the lender because no collateral is required, which means you may pay more in interest to help offset that added risk.
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There are many occasions when you may need to take out a personal loan, such as to cover an emergency expense, pay off high-interest credit card debt, or pay for a big-ticket item for which you can’t afford outright. A personal loan, which typically has a lower interest rate than a credit card, can be a smart way to get the money you need on short notice.
However, there are two types of personal loans you can choose from when looking at your financing options.
Many of the best personal loan lenders offer both secured loans and unsecured loans to borrowers, depending on their need for the funds. Each loan option has its advantages and downsides which should be considered before signing your loan agreement. Here’s what you need to know.
In this guide:
- The Difference between Unsecured and Secured Loans
- Applying for Unsecured Loans
- Applying for Secured Loans
- Evaluating the Risks of a Loan
The Difference Between Unsecured and Secured Loans
The Collateral Required
The biggest difference between unsecured and secured loans is the need to provide collateral — a tangible asset, such cash, or your home — which the lender can seize if you default on your loan. You do not need to have an asset to use as collateral for an unsecured loan. Instead, the lender evaluates your credit history and income to see if you qualify. Because the risk to the lender is higher without collateral, you may pay more for an unsecured loan.
With a secured loan, collateral is required. A mortgage is the most common type of secured loan, where a property is pledged as the asset. However, lenders also offer secured personal loans where a bank account is used as collateral. In this case, what you pay for borrowing may be lower, but you are also putting that asset at risk should you fail to make payments in the future. In many cases, the item used as collateral is the same item you’re using the loan funds to purchase, such as the vehicle purchased with an auto loan.
The Eligibility Requirements
Both secured loans and unsecured loans require you to submit an application so that a lender can evaluate your potential risk as a borrower.
With a secured loan, like a car loan, you may have an easier time getting approved because the lender is taking on less overall risk. An unsecured loan may be harder to qualify for since only your credit history, credit score, and income are taken into account.
>> Read More: What Credit Score is Needed for a Personal Loan?
The Loan Amounts
Secured loans and unsecured loans also differ in terms of the loan amounts that are typically available. Without collateral, personal loans may be available in amounts ranging from a few hundred dollars up to $50,000. Although this may be more than what is available through credit cards, it may not be high enough to cover certain expenses, depending on the loan purpose.
Secured loans, on the other hand, may have much higher borrowing limits, but this depends on the availability of collateral used to back the loan. If you’re taking on a secured personal loan, you’re likely to have access to a maximum loan amount only as high as the value of the asset you pledge.
The Interest Rates
Interest rates on secured and unsecured loans also vary. Lenders offering secured loans do so with lower interest rates since the risk they take on is lower. Again, if you don’t pay, the lender can seize your collateral to help cover the losses they incur. Personal loans that are unsecured have higher interest rates because there is no collateral to offset the risk of non-payment.
The Repayment Terms
Both secured and unsecured loans have similar repayment terms, but often, secured loans like a mortgage will have far longer repayment terms than an unsecured loan. Personal loans that do not have a collateral requirement may have a repayment term of up to five or seven years at the most. Depending on how much you borrow, this can create a significant monthly payment.
Secured loans may have repayment terms extending up to 30 years, but these longer repayment terms are typically reserved for mortgages and student loans.
Applying for Unsecured Loans
Applying for unsecured loans is a relatively simple process, whether you use a traditional financial institution, credit union, or an online lender. You provide details about your income, the loan amount you want or need, and your credit so that a lender can evaluate your creditworthiness. Some lenders can approve an unsecured loan application in a few minutes, while others may take up to a few days.
Borrowers do incur some risk when applying for an unsecured loan, including temporary hits to their credit scores. Typically, lenders only do a soft credit pull when considering you for pre-qualification, which does not impact your credit score; however, to finalize a loan offer, they’ll have to complete a hard inquiry, which stays on your credit report for up to two years.
Although the impact to your credit score is small, it is something of which you should be aware, especially if you plan to apply for other types of credit in the near future. You should also be prepared to start making payments as soon as your loan is approved, so be sure to consider your budget when evaluating loan offers.
Applying for Secured Loans
The application process for a secured loan is similar to an unsecured loan, except you also have to provide information about the collateral you plan to use. Most secured loan lenders will also look at your credit score and history when you apply for a secured loan, and they are likely to ask for verification of the asset you want to use as collateral. This extra step in the process may mean waiting longer for your loan proceeds.
You have a greater risk when applying for and getting a secured loan if you become unable to make payments. Not only does your credit score take a hit for missed payments, but you could also lose the collateral you used to back the loan.
As with unsecured loans, be sure to think about what you can afford in monthly payments — and what you can afford to lose in terms of collateral — before signing on the dotted line.
Evaluating the Risks of a Loan
Taking out any type of loan, whether a mortgage, personal loan, or auto loan, comes with some degree of risk. You receive a lump-sum payment for a fixed loan amount, which you pay back plus interest over a specific period of time. The monthly payment stays the same over the length of the loan (unless it comes with a variable interest rate), so you need to ensure your budget allows for this fixed payment now and in the future.
When it comes to personal loans that are either secured or unsecured, you also need to weigh what you gain from the loan against what you might have to give up in the event you become unable to repay your loan.
With unsecured loans, you do not have to bring anything to the table except proof of income and a good credit score. However, adding new debt and another monthly payment can be a hit to your budget. With secured personal loans like a mortgage, you are pledging some type of asset to secure the loan. If you fail to make payments, the lender can recoup its losses by taking ownership of that asset.
Secured and Unsecured Loans: Which Is Right for You?
Getting a loan can be a smart alternative to using credit cards because it usually offers lower interest rates and predictable monthly payments over time. However, deciding between an unsecured loan and a secured loan can be difficult if you don’t know the differences.
Take the time to think through the risks of both types of loans, the cost of borrowing, and your ability to use collateral for the loan before making your choice.
Check out our page to learn more about how personal loans work.
Author: Melissa Horton