Secured vs Unsecured Personal Loans – What You Need to Know
There are two basic types of personal loans: secured and unsecured. The terms sound a little technical, but the idea is simple. With a secured loan, you use something of yours for collateral. With an unsecured loan, there is no collateral. When you understand this difference, you will get a personal loan that fits well into your risk profile and budget.
What does secured mean
A secured personal loan is linked to an asset. Think of it as handing the lender a spare key. If you don’t make the payments on the loan, the lender can use that key to claim the asset and sell it to cover the amount due on the loan. Typical items used for collateral include a car title, savings account, or certificate of deposit.
Since the lender has that cushion, secured loans can be available at lower rates, or you can borrow more. You may also qualify more easily if your credit is limited or damaged. But the downside is real. If you miss payments on this kind of debt, you may lose the asset. The risk should be of paramount importance in your mind when putting together your plans.
Here is a quick example. You have your paid-off car. You take a loan against it to cover a $2000 medical bill. The rate is lower than you were offered elsewhere. If you pay your bill on time, you’re in great shape. If you fall behind on your payments, it can cost you the car. For many people, that guarantees that they stay on top of the payments. For others, it is just another stress that they do not need.
What does unsecured mean
An unsecured personal loan has no collateral. The lender looks at your credit, income, and debt in determining if you qualify, and at what rate. Since there is nothing for the lender on which to lean, he takes more risk. The rates may be higher and the amounts smaller than with secured loans. The approval is made on the basis of your credit profile and ability to repay.
It’s like borrowing from another friend who lives next door without providing anything in the way of collateral. Because they know you and have some history with you, they will lend it to you. You will get a better rate, say, if you are employed and have a good record for paying the bills promptly.
How risk shows up in the cost
Risk never hides. It is priced right in. Lenders price their loans according to the risk that they will not be repaid. Security reduces that risk, so secured loans are generally less expensive. Unsecured loans are more expensive because the risk is greater. Your credit rating, income, and current debt load are important in both types of loans.
Which one fits your situation
Consider this simple questionnaire:
- Do you have an asset that you could pledge safely without affecting your daily living if things go wrong?
- Are you comfortable with the thought you could lose that asset if you fall short on payments?
- Do you need a lower rate or a larger amount that unsecured loans cannot give you?
If your answers are yes, then a secured loan may fit the bill. If you prefer to keep your assets off the table, or you have no assets to pledge, an unsecured loan keeps things simpler. You will still have to qualify, and the rate may be a bit higher, but your car or savings would not be in jeopardy.
If you want a quick look at amounts, rates, and key points, see our personal loans overview.
Credit impact and timelines
Each of these types of loans can potentially affect your credit. If you make timely payments, you may be able to develop a good credit history. If you make late payments, it will hurt. If you cannot pay a secured loan, the loss of the property backing the secured loan is a blow not only to your credit history but also to your living conditions. Do not lose sight of the repayment schedule. Select a loan term which won’t create financial strain to make the payments as required.
Fees and fine print
Before you commit, make sure that you have a clear understanding of everything that is in the loan agreement. Pay special attention to all the different types of costs that may be paid at the outset of the loan, the penalties for making late payments, and any restrictions on paying back the debt ahead of time.
If the loan is a secured one, find out how the lender intends to protect your collateral and how you will get it back after you have paid it all off. With unsecured loans, find out how interest is determined and whether the same rate will apply throughout the term of the loan.
A little time spent carefully reviewing the paperwork now may save you from unexpected problems later on.
A quick side by side example
Say you need $3,000. A secured offer has a lower rate and a 24-month term, but your car must be pledged. An unsecured offer has a higher rate with the same term, but no collateral is necessary. If the secured rate saves you $20-30 a month and you are reasonably sure you can pay on time, it’s probably worth it. If you are uneasy at the thought of losing your car, then the unsecured route might be the safest, even if it costs more.
The bottom line
Secured loans mean lower rates of interest, but you have to pledge some property as security. Unsecured loans do not require collateral since the lender just goes on your credit rating, but they will result in higher interest rates. There’s no one best type of loan for everybody.
Consider your tolerance to risk, your budget, and the degree of flexibility you want. Take into consideration total costs and monthly payments, and the possible downsides in selecting a loan that best fits both now and for the long term.
References
- NerdWallet. “Secured vs. Unsecured Loan: What’s the Difference?” https://www.nerdwallet.com/article/loans/personal-loans/secured-vs-unsecured-loans