The terms “secured loan” and “unsecured loan” are often mentioned when you’re trying to borrow money. But what does this mean and how does it affect your loan? What options do you have and which type of loan should you go with?
First, what is a secured loan?
A secured loan is a loan in which the borrower, you, pledges an asset such as a car, property, or jewelry as collateral for a loan. The loan is then secured against the collateral pledged and if you can’t pay back or default on the loan, your lender takes possession of your asset.
An example of this is a home mortgage. A home mortgage is secured by the property which acts as the collateral for the mortgage. If you fail to make your mortgage payments, the lender has the right to foreclose your home in an effort to recover the balance of the mortgage.
Other examples are a car loan, title loan, and pawn loan.
What is an unsecured loan?
An unsecured loan is the opposite - it is not secured by any asset or property. If you cannot pay back your loan or default on the loan, the lender cannot recover a car or house. Instead, the lender will seek repayment with you and go through the courts if necessary.
An example of an unsecured loan is a normal credit card! You might not think of this as a loan but you’re still borrowing money on your credit card and paying it back monthly! If you cannot pay back your credit card, the credit card issuer will likely go through normal debt collection agencies to seek repayment.
Other examples are a payday loan, personal loan, and most installment loans.
Pros and Cons of Secured and Unsecured Loans
So isn’t it always better to have an unsecured loan since the lender won’t be able to seize your property? Not always and each situation is different. There’s no free lunch here! Secured loans may have lower rates since there is less risk for the lender. In addition, some loans such as mortgages and car loans have a standard practice of being secured by the property.
- Potentially a lower rate. A secured loan may have less risk for the lender so the bank or financial institution may charge a lower interest rate.
- Potentially easier to qualify for. If you have less than good credit, a secured loan with a pledged asset may make it easier for you to qualify for the loan
- Build credit history. You can build positive credit history by making on-time payments for your secured loan.
- The application can be more complicated. Have you ever gotten a mortgage or gotten a car loan? There can be a lot of paperwork and lots of parts such as a property appraisal or a deed of trust.
- You may lose your property. If you fail to make payments and default on your secured loan, the lender has to right to possess your property to recover on some of their loan losses.
- You could be “upside down.” What does this mean? If your property value falls significantly, you may owe more on your loan than the property is worth! This can happen with a car, house, or any other secured loan when the asset drops in value. It’ll be hard to sell your property because your sale proceeds won’t be able to pay back your loan.
- Potentially access money faster. Since an unsecured loan can have less paperwork and requirements, you will get money in your pocket or bank account faster.
- The lender can’t take your property. An unsecured loan has no collateral or asset pledged. Therefore, if you fail to pay and default on an unsecured loan, the financial institution such as your bank or credit union cannot take your property.
- Low rates if you have a high credit score. Rates on an unsecured loan may be just as low as a secured loan for high credit score borrowers. This will vary depending on the lender and your financial situation.
- Most lenders will do a credit check. Your credit score will be checked even if it’s not negatively impacted. Since a lender has no asset to possess if you fail to pay back your loan, lenders will look at other factors such as your credit score, impact, and credit report.
- Interest rates may be higher and loan amounts may be smaller. Since lenders do not have property as collateral, an unsecured loan tends to be riskier, resulting in higher interest rates and lower loan amounts than a secured loan.
- There are consequences to not paying back. Just because a lender can not seize property collateral doesn’t mean there are no consequences of defaulting on an unsecured loan. Your credit score will suffer, debt collection agencies will contact you, and you may be sued in an attempt to collect on the debt.
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Types of Secured Loans
- Home mortgage - A home mortgage is a type of secured loan given by a bank, mortgage company, credit union or other financial institution for the purpose of purchasing a primary or investment home. The collateral used for the mortgage is the home itself and if you can’t pay back the mortgage, the lender can possess the home. Mortgage rates can be variable or fixed and the term of the loans is usually 10 to 30 years.
- Auto or car loan - An auto loan is a secured loan you take out to purchase a motor vehicle which can include a car and motorcycle. The collateral used for the auto loan is the motor vehicle itself. Most auto loans are structured as an installment loan where the loan is paid off in monthly principal and interest payments. The loan often has a fixed rate of interest and a term of 3 to 5 years.
- Secured credit card - A secured credit card is a credit card that requires a cash deposit before you can pay for products and services using your card. The cash deposit reduces the risk to the issuer of the credit card. The amount of your cash deposit is usually equal to your credit limit. If you deposit $200, you can spend up to your credit limit, $200. Secured credit cards are often used by those with bad credit to build credit history.
- Home equity line of credit (HELOC) - A home equity line of credit is a revolving line of credit secured by the home property. A HELOC resembles a second mortgage but acts more like a credit card in function - it is also different from a second mortgage or a home equity loan which is usually used for remodeling or a large project. Rates on HELOCs are usually variable and amounts are dependent on the lender and can be changed at any time.
- Credit builder loan - A credit builder loan is a loan in which the amount you borrow is placed in a bank account as you make payments, allowing you to build credit history. You cannot access what you borrow since it is being used as the collateral to secure your loan. Once the term of the loan is up, you can access the money you borrowed. A credit builder loan is a way to save money and build credit history at once.
- Title loan - A title loan is a secured loan that uses your automobile or car title as collateral. It’s usually repaid in a month and lenders often offer to renew or rollover the loan at significant fees or costs. Lenders tend to not check your credit history and market to those with bad or no credit history. Because the loan is secured by your motor vehicle - which can be how you get to work - be careful when getting a title loan. If you default on your loan, you could put your livelihood at risk.
- Pawnshop loan - A pawnshop loan is a secured loan that uses the property you “pawn” as collateral for the loan. Interest rates vary but average around 200% annual percentage rate of interest (APR). The loan amount you’ll receive is usually 25-60% of the resale value of the pawned item and the pawnshop may require proof of purchase for your item. Commonly pawned items include jewelry, firearms, and electronic equipment.
Types of Unsecured Loans
- Personal loan - A personal loan is an unsecured loan typically 2 to 7 years in length that you borrow from a bank or financial institution. You can usually use the funds from a personal loan on anything you wish. Annual percentage rates of interest (APR) range from 6% up to 36% depending on the lender and your credit situation.
- Student loan - A student loan is an unsecured loan that acts as financial assistance designed to help students pay for school-related costs such as books, tuition, supplies, etc. Many loans are offered to college students at a low-interest rate and interest payments may be deferred until the student finishes school. There are private as well as federal student loan programs.
- Possible installment loan - A Possible loan is offered by Possible Finance and is an unsecured installment loan normally up to $500 depending on the state. Repayment is split into 4 payments over several months, allowing you to catch your breath rather than get hit w/ a one-time repayment like a traditional payday loan or paycheck advance. Possible reports to two major credit bureaus so you can build positive credit history with on-time repayments.
- Credit card - A credit card is an unsecured line of credit where you can borrow money from a bank to purchase products and services. There is no interest due if you repay the money you borrow within the grace period, usually 25-30 days. If you don’t pay it back during that time of period, you owe the bank interest calculated in the form of an annual percentage rate (APR).
- Payday loan - A payday loan is a short-term, small-dollar and usually a high-cost loan that is usually repaid back on your next payday. The APRs average about 400% but the application process is usually fast and credit requirements are low. Most borrowers who use payday loans have an emergency expense or need money fast.
- Payday advance app - A payday advance app is an app that advances cash that you earn from your job early to you. Apps like Earnin, Dave, and Brigit are all considered payday advance apps. You might be surprised they aren’t considered a loan under current state regulations and aren’t required to report interest rates, APRs, and other important financial disclosures. If you’re using a payday advance app, just watch out for the tips, membership fees, and subscription costs - they can add up!
- Revolving and unsecured line of credit - A credit card is a form of an unsecured line of credit but you can also get a revolving and unsecured line of credit from a bank or financial institution directly. A line of credit is a preset amount of money a bank or credit union has agreed to lend to you. You can draw upon the line of credit as needed up to the maximum amount. You’ll pay interest on only the amount you borrow against the line of credit.
Credit reporting for both secured and unsecured loans
Secured and unsecured loans are similar in terms of credit reporting. Although lenders are not required to report on-time payments, late payments, delinquencies, etc. to all of the credit bureaus as per the Fair Credit Reporting Act, many lenders report to at least one of the major credit bureaus. Possible Finance reports all payments to Experian and TransUnion to help our customers build credit history.
Negative information relating to missed or late payments can drop your FICO score 60 to 100 points and stay on a credit report for up to 7 years. The credit score impact is similar for both a secured and unsecured loan. If there is a dispute or a lender has provided inaccurate data, you can dispute and an investigation into the claim must start within 30 days.
There are differences in how the loans will show up on your credit report if you do not pay back the loan. An unsecured loan, if delinquent more than 150 days, will read “charged-off”, meaning the lender wrote the debt off as a loss. A secured loan, if the lender repossessed your property, will show up as a “repossession” or a “foreclosure” (for a home). Any of these types of delinquencies will seriously affect your credit score, usually dropping it by over 100 points.
Types of collateral for a secured loan
The most common collateral used for a secured loan include:
- Certificate of deposit
- Art and Collectibles
- Investment or savings account
But people can get pretty creative! Here are less frequent and interesting forms of collateral:
- Farming equipment
- Insurance policies
- Wheels of Parmesan cheese
- Lottery ticket
What happens if you default on a secured or unsecured loan
Except for repossession, defaulting on both a secured and unsecured loan works similarly. For an in-depth dive into what happens when you default on an unsecured loan, you can read our article on defaulting on a payday loan, a type of unsecured loan.
If you can’t pay back your secured loan, your lender - bank, credit union, or financial institution - will repossess your property. However, in the case of homeowners and other property owners, the lender must follow a set procedure which may include notifying you and giving you a chance to catch up on payments. Foreclosure (when a lender repossesses a home) law is also complex so we recommend getting the proper help and advice for your specific situation.
Note that just because your property has been repossessed does not mean you’re off the hook for your loan! You may still owe your lender a remaining balance, especially if the resale value of the property lender took is lower than your outstanding debt amount. There were many people in the subprime mortgage crisis of 2008 that sold their homes for less value than their loan amount or was foreclosed on and still had amounts to pay on their loan.
Unsecured loans have no property associated with the loan but the lender and later on, a debt collection agency will contact you about the loan. Once payment is 30 days past due, the lender can report the late payment to the credit bureaus, thereby hurting your credit score. You will likely receive incessant phone calls, text messages, and emails from your lender and debt collection agencies. The lender and debt collector may also take you to court to seek repayment through wages or to place a lien on your house. Lastly, as with a secured loan, a default on an unsecured loan will stay on your credit report 7 years - with the exception of student loans.
Student loans, a type of unsecured loan, are unique in that some student loans are lent out by the federal government and some by private institutions. Federal student loans have a different set of rules and regulations including a longer period before delinquency and default, more difficulty in declaring bankruptcy, and others. You can read more at the Federal Student Aid website.
Why would you choose a secured loan over an unsecured loan?
Secured loans can potentially have a lower interest rate (annual percentage rate of interest or APR) than an unsecured loan. In addition, they’re potentially easier to qualify for and tend to have higher borrowing amounts. For example, have you ever gotten or heard of a home loan that’s unsecured? It’s very rare!
However, secured loans are not necessarily better than an unsecured loan. A secured loan has its uses, especially when buying a home or getting a car, but you don’t want a secured loan for everything! Perhaps you just need some additional money for medical bills or money for higher education. You don’t want to lose your house or car because you can’t pay back those loans!
Possible Finance is a good option for an unsecured loan and a better alternative than payday loans, cash advances, and bank overdrafts. If you can’t qualify for lower APR unsecured loans such as credit cards, bank lines of credit, or personal loans due to your credit score, Possible is available since we don’t use your FICO or Vantage credit scores to determine whether we can give you a loan. Once you receive your money, you can pay back the loan in installments and build credit history. Possible reports to two major credit bureaus - Experian and TransUnion - so you get the benefits of paying back your loan on time.