When you take out a loan, you’ll apply for either a secured or unsecured loan. On the surface, these two loan types are similar — you borrow money, the lender collects interest, and you make monthly payments until you’ve paid back the borrowed amount (plus accrued interest). But take a closer look and you’ll find some big differences.

Here’s everything you need to know about secured vs. unsecured loans:

 

What is a secured loan?

A secured loan is backed by an asset, such as your car or home. If you stop making payments on the loan, the lender can seize the asset—known as repossession or foreclosure—and try to sell it to recoup their money.

 

How does a secured loan work?

With secured borrowing, the value of your collateral plays a primary role in determining the size of your loan. Typically, lenders use an equation known as “loan to value ratio” (or LTV) to determine your maximum borrowing limit. For example, if you’re buying a car worth $10,000, the auto financer might be willing to lend you $8,000. In this scenario, the LTV is 80%.

But collateral is not the only thing that influences your borrowing amount or terms such as your interest rate. Lenders also assess your credit profile—regardless of whether the loan is secured or unsecured.

 

Secured loan examples:

  • Home loans: Due to the large lending amount, mortgages are backed by your home.
  • Auto loans: With auto loans, your lender typically keeps the title until you pay off your total due.
  • Savings-secured loans: Backed by your savings account, these loans are often used to help you build credit.
  • Title loans: Intended to be short term loans, a lender holds the title to your vehicle until you pay off the loan. Title loans can carry strict repayment terms with quick repayment periods, making these loans riskier than other types of secured loans.

What is an unsecured loan?

An unsecured loan is not backed by an asset, which means there is no collateral.

If you stop making payments on an unsecured loan, the lender can still try to recoup their money—but it won’t be as simple as seizing and selling the collateral.

 

How do unsecured loans work?

For an unsecured loan, the loan amount is largely determined by your credit history and income. The lender assesses how much debt they think you can responsibly manage and pay back on time. For certain types of unsecured loans, the amount can also be subject to state laws.

 

Unsecured loan examples:

  • Unsecured personal loans: Sometimes known as unsecured signature loans, borrowers typically receive their loan in one lump payment and can use the funds for nearly anything including home repairs, covering medical costs, and paying for unexpected expenses.
  • Debt consolidation loans: With a debt consolidation loan, the lender pays your creditors, essentially consolidating your debt under one loan. You, in turn, make monthly payments on the loan.
  • Student loans: Federal and private student loans are both unsecured, although they do differ from consumer debt in other ways.
  • Payday loans: Payday loans are small loans designed to be repaid within one to two paycheck cycles. Interest rates can be as high as 400% for these loans, according to the Consumer Financial Protection Bureau.

Are credit cards secured or unsecured?

Credit cards can be either secured or unsecured. Just like a secured loan, a secured credit card requires you to back it with an ‘asset’ — which in this case is cold, hard cash. Basically, you fund the credit card before you can make expenditures on it (a lot like a debit card).

Unsecured credit cards are far more common — these cards allow you to rack up debt without any cash backing up your spending.

Why would you want a credit card that requires you to pre-fund it?  There are a few reasons you might go for a secured credit card vs. an unsecured credit card:

  1. You’re looking to build or rebuild credit.  Since the card is pre-funded, it’s easier to get approved for an unsecured credit card.
  2. You want the benefits of a credit card without the temptations.  A secured credit card may offer rewards or miles but doesn’t allow you to spend outside of your comfort zone.
  3. You want your kid to learn how to use credit.  Secured credit cards can be a great way to introduce your offspring to the world of credit — without the surprises on the parent’s bill.

Secured vs. unsecured loan: How to choose

While both options have the potential to help you achieve your financial goals (and boost your credit score, providing you make payments on time), each has its advantages:

 

Benefits of secured loans:

  • Lower rates (typically): Since lenders will have an easier time recouping any potential losses by seizing collateral, they can often offer lower interest rates for secured loans.
  • Easier qualifications: Secured loans as viewed as less risky, so you may have an easier time qualifying if you have limited credit or have had past credit problems.

Benefits of unsecured loans:

  • No property risk: While you will still face financial consequences if you default on your loan, you don’t run the risk of losing your home or other important assets.
  • More freedom: Many types of secured loans are tied to certain financial events like buying a home, building credit, or buying a car. Unsecured loans, like personal loans, offer greater flexibility.

Which type of loan is right for you?

Like all financial decisions, this one is personal—it depends on your unique financial situation and goals. For example, some borrowers aren’t comfortable pledging their home or car as collateral for a loan, so they opt for an unsecured loan. Other borrowers, however, might have damaged credit profiles and find the terms on a secured loan to be more attractive. Whichever you choose, be sure to review the loan carefully before signing up so you know what you’ll owe and what your responsibilities are.

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