Whether you’re trying to buy a home or looking to get a college degree, you may need to take out a loan to finance your goals. If you’re seeking out your first loan, know that borrowing money is a common practice and you don’t need a degree in economics to understand it! Learning more about loans and the different types can help you make informed decisions and take control of your finances.
Loans take many forms but they all fall within two common categories: secured vs. unsecured loans. Whether you’re approved for either type of loan depends on your creditworthiness. Creditworthiness refers to how responsible you are at repaying debt and if it’s worthwhile or risky to grant you new credit. It’s helpful to be aware of your credit prior to seeking out a loan so you know where you stand.
Now that you’re familiar with the role creditworthiness plays in getting a loan, let’s discuss the differences between secured and unsecured loans, the advantages and disadvantages of each, and which one may be right for you.
What’s the Difference Between Secured vs. Unsecured Loans?
The main difference between secured and unsecured loans is how they use collateral. Collateral is when something of economic value is used as security for a debt, in the event that the debt is not repaid. Usually collateral comes in the form of material property, such as a car, house, or other real estate. If the debt is not repaid, the collateral is seized and sold to repay all or a portion of the debt.
Key Difference: A secured loan requires collateral, while an unsecured loan doesn’t require collateral.
What Is a Secured Loan?
A secured loan requires collateral as security in case you fail to repay your debt. If secured debt is not repaid, the collateral is taken. In addition to seizing collateral, lenders can start debt collection, file negative credit information on your report, and sue you for outstanding debt. This generally makes secured loans more risky for the borrower.
Conversely, collateral decreases the risk for lenders, especially when loaning money to those with little to no credit history or low creditworthiness. Less risk means that lenders may offer some leeway regarding interest rates and borrowing limits. See the list below to review other typical secured loan characteristics.
Characteristics of a Secured Loan:
- Presence of collateral
- Typically more risky
- May require a down payment
- May sell property to repay loan
- Generally lower interest rates
- Longer repayment period
- Higher borrowing limits
- Easier to obtain for those with poor or little credit history
- Typically less risky
- Lender can take your collateral
- Lender can hold the title to your property until loan is repaid
Secured Loan Examples
The most common uses of a secured loan are to finance large purchases such as a mortgage. Usually, these loans can only be used for a specific, intended purchase like a house, car, or boat. A home equity loan is another example of a secure loan. Some loans like business loans or debt consolidation can be secured or unsecured.
What Is an Unsecured Loan?
An unsecured loan doesn’t require collateral to secure the amount borrowed. This type of loan is granted based on creditworthiness and income. High creditworthiness makes an unsecured loan more accessible.
The absence of collateral makes this type of loan less risky for borrowers and much riskier for lenders. If unsecured debt is not repaid, the lender cannot seize property automatically. They must engage in debt collection, report negative credit information, or sue. As a result of the increased risk, unsecured loans have characteristics that attempt to reduce the risk. These may include higher interest rates or lower borrowing limits, and you can see more in the list below.
Characteristics of an Unsecured Loan:
- No collateral required
- Typically less risky
- Qualify based on credit and income
- Stricter conditions to qualify
- Generally higher interest rates
- Lower borrowing limits
- Typically more risky
- Lender can’t take property right away if you default
Unsecured Loan Examples
Common unsecured loans include credit cards, personal loans, student loans, and medical debt. Debt consolidation and business loans can also be unsecured. In each of these instances, collateral is not required and you are trusted to repay your unsecured debt.
Advantages and Disadvantages to Consider
When it comes to deciding on the type of loan you need, it’s important to consider the advantages and disadvantages of each.
Secured loans present advantages for repayment, interest, and borrowing amount, but have disadvantages regarding a borrower’s risk and limitations of use.
- Bigger borrowing limits
- Less risk for lenders usually means lower interest rates for borrowers
- Longer repayment period
- Available tax deductions for interest paid on certain loans (e.g., a mortgage)
- Risky for borrower (potential for loss of collateral like home, car, stocks, or bonds)
- Specifically for intended purpose (e.g., a home, but home equity loans are an exception)
Unsecured loans can be advantageous for borrowers regarding risk and time, but they pose a disadvantage when it comes to interest rates and stricter qualifications.
- Less risky for borrower
- Useful loan if you don’t own property to use as collateral
- Quicker application process than for a secured loan (e.g., a credit card)
- More risky for lenders usually means higher interest rates for borrowers
- Hard to qualify for if you have low creditworthiness or inconsistent income (can qualify with a cosigner)
Take a look at the chart below to compare the key advantages and disadvantages between secured and unsecured loans.
|• Lower interest rates
• Higher borrowing limits
• Easier to qualify
|• No risk of losing collateral
• Less risky for borrower
|• Risk losing collateral
• More risky for borrower
|• Higher interest rates
• Lower borrowing limits
• Harder to qualify
Which Loan Type Is Best for You?
After considering the advantages and disadvantages of both loan types, it’s helpful to know which one is the best for certain circumstances. Here are some common contexts in which one may be better than the other.
- A secured loan may be best if you’re trying to make a large property purchase or don’t have the best credit. The piece of property that you are purchasing can be used as collateral if you don’t already own other property. Additionally, this loan is more accessible for you if you have low creditworthiness and may be more advantageous with lower interest rates.
- An unsecured loan may be best if you have high creditworthiness and a steady income. High creditworthiness helps you meet strict qualification criteria and can also help you obtain better interest rates (given that this type is characterized by higher interest).
Overall, secured and unsecured loans are each useful in different situations. Remember that the key difference is that unsecured loans don’t need collateral, while secured loans do. Secured loans are less risky for the lender and may allow for some advantageous repayment conditions. On the other hand, unsecured loans are risky for the lender, and they often come with stricter conditions that try to lessen that risk.
It is important to make smart financial decisions such as repaying debt on time and maintaining a good credit history. High creditworthiness is the key to getting the best conditions on any loan. No matter your circumstances, identifying which loan type is best for you depends on your specific credit and goals. Visit our loan center for help in deciding which loan is right for you.
Sources: Consumer Financial Protection Bureau