When exploring financial products like personal retail loans, it is important to understand the difference between “secured” and “unsecured” loans. Both types of loans can be useful for funding various purchases as long as you know what you are getting into.
Understanding the differences between secured and unsecured loans can help you make wise purchasing decisions and protect your financial health.
What Is a Secured Loan?
A secured loan is a type of loan that is backed or “secured” by some form of collateral or something you own. The collateral must be something with ntrinsic value and is typically a physical object or piece of real property. Vehicles and homes are the two most common examples of collateral used to secure a loan.
Many lenders prefer issuing secured loans for one simple reason: they have an option for recourse if a borrower defaults. The financial institution can foreclose on a house or repossess a vehicle if a borrower stops paying the loan. The financial institution can resell the house or vehicle to recoup their losses.
Since secured loans are less risky for lenders, they typically offer borrowers access to much lower interest rates and better repayment terms. In peak market conditions, borrowers with excellent credit can obtain interest rates as low as 3% on home or auto loans.
Additionally, there are instances when you can put an item up as collateral to secure a personal loan.
For example, let’s say you have a vehicle that is paid off and valued at $30,000 when you incur an unexpected medical expense and need to take out a personal loan of $10,000. If you cannot get approved for an unsecured loan of that amount, some lenders might allow you to put your vehicle up as collateral to secure the loan.
What Is an Unsecured Loan?
With an unsecured loan, the borrowed money is not backed or secured by any collateral. Instead, lenders give borrowers money in exchange for a promise to repay the loan at an agreed-upon interest rate.
While borrowers will not forfeit any real property if they fail to repay the loan, what’s at stake is their credit score. The lender could also sell the debt to a collection agency that will pursue the borrower to recoup the unpaid balance on the loan.
The three common types of unsecured loans include:
- Student loans
- Revolving loans
- Personal loans
While student loans do not require collateral, they typically must be used for college-related expenses, such as tuition, books, meal plans, and lodging. However, some student loans include very few restrictions regarding how recipients can spend the money.
Credit cards are the most common example of revolving loans, and personal lines of credit are another. These financial products enable borrowers to repeatedly pay down and borrow funds from a lender, so long as they have not reached their credit limit.
Personal loans have become an increasingly popular type of unsecured loan in recent years. Personal loans can feature fixed repayment terms and monthly payments. Personal loan funds are often disbursed in a one-time, lump sum payment.
Key Differences Between Secured and Unsecured Loans
In addition to the need for collateral, the key differences between a secured and unsecured loan are:
Secured loans generally have much lower interest rates than unsecured loans. This is because lenders incur minimal risk when funding the purchase of real property, such as a vehicle or house. Unless a borrower has severely damaged credit, interest rates for secured loans are typically in the single digits.
On the other hand, even borrowers with good credit might have an interest rate of 10% or higher on an unsecured loan. Naturally, the better your credit score, the lower rates you will qualify for.
Lending limits are among the most notable differences between unsecured and secured loans. Your specific borrowing limits for either type of loan will vary based on factors such as your income, credit score, and repayment history. Still, you will be able to borrow significantly more when taking out a secured loan versus an unsecured one.
When applying for a secured loan, you may be able to obtain hundreds of thousands of dollars in funds to cover the purchase of a home. Conversely, you may only be able to borrow a few thousand dollars when taking out an unsecured loan.
If you have very good credit (740 and higher), you might be able to borrow $10,000 or more using an unsecured retail loan or credit card.
The qualification requirements for both secured and unsecured loans can be quite strict, especially if you are attempting to borrow a large sum of money. However, lenders are more likely to be lenient about credit score requirements when approving secured loans because they have some recourse if borrowers’ default.
You can still qualify for an unsecured loan if you have bad credit, but you probably will not be able to borrow as much and may have a higher interest rate.
Restrictions on How You Can Use the Funds
Secured loans include very specific restrictions for how you can use the funds. In fact, lenders typically wire funds directly to the entity selling the item you are purchasing. For example, if you are buying a new car, the lender will send the funds for the vehicle to the dealership, not to you.
Alternatively, when you receive an unsecured loan, you can usually spend the money on whatever you choose.
With that being said, the lender may ask what you plan to do with the funds, especially if you are applying for a debt consolidation loan or some other financial product designed to reduce your monthly financial obligations. Point-of-sale loans are also typically paid out directly to your merchant.
Are Unsecured Loans “Bad”?
Unsecured loans sometimes get a bad rap because they have higher interest rates than secured loans.
But unsecured loans are neither “bad” nor “good.” They are simply financial products that can benefit borrowers in the right circumstances. When considering whether to take out an unsecured loan, make sure that the loan features a competitive interest rate and clear repayment terms. Also, ensure that you can afford the monthly payment on your loan.
Following these simple rules will help you build your credit and protect your financial health by making wise borrowing decisions.