All loans can be divided into two broad categories: unsecured and secured loans. While both types of loans give you access to credit, there are some key differences when comparing an unsecured vs secured loan.
When looking to finance a large purchase or event, you’ll encounter both types of loans. Understanding what the key differences exist between either loan can help you figure out which is the best fit for your personal financial situation.
What is the Difference Between an Unsecured vs Secured Loan?
The major key difference between unsecured and secured loans is that secured loans take collateral, usually a valuable asset, to hedge against you being unable to pay back what you borrowed. This can take the form of a house, a car, or anything else of value. Unsecured loans are loans that you take out from a lender, with nothing guaranteeing that you’ll pay it back.
Since lenders have the ability to repossess that asset, secured loans are much less risky. This means that you can usually enjoy lower interest rates and borrow a greater amount of money. The more valuable the asset you are borrowing against, the more credit you can gain access to (home equity lines of credit, for example, borrow against the value of your home).
Some examples of secured loans include mortgages and car or vehicle loans. Student loans are also secured loans, though not against a physical asset. Most student loans will garnish your wages after you graduate, and are thus secured against your future income.
They tend to be, but are not always, longer term, with preset payments at regular intervals. Some secured loans will have variable interest rates, which can cause your payments to increase in the future.
Secured loans are usually easier to get if you have a low credit score. This is because even if you do default on the loan, the lender is still able to get something of value from it.
Unsecured loans are riskier for lenders. They are not able to take possession of your asset (or garnish your wages) if you default on the loan.
This means that unsecured loans tend to be smaller in nature, and come with higher interest rates. Lenders will offer you lower interest rates if you have a good credit score, but they will still be higher than secured loans. It can be hard to find a lender who is willing to give you an unsecured loan if you have non-existent or poor credit.
Cash loans, personal loans, and other forms of short-term lending are unsecured loans. Credit cards and some lines of credit are also unsecured. Missing a minimum payment will hurt your credit rating and usually cost you additional fees, beyond the normal interest.
In the event that you don’t pay back the loan, the lender has to take you to court to try and get their money back instead of repossessing your assets. They can also hire a collection agency (or sell your debt to them) in order to get some money back.
Collections agencies will continue to contact you in an effort to get what they are owed. They can sue you, and if proved successful, can have liens or other penalties imposed on you.
Liens are imposed on property, and allow the collection agency to repossess the item until the debt is paid. Unlike secured loans, the property does not transfer ownership, but you still can’t use it until you pay back your debt.
Avoid Overextending Your Borrowing
The major thing to keep in mind is that it doesn’t matter what type of loan you choose: you need to make sure that the loan that you are applying for falls within your financial means of paying back. Not paying back either type of loan can carry serious penalties, and can ruin your financial future.
Defaulting on a loan can leave a mark on your credit report for up to seven years. This can make it very hard for you to access credit for important life events, like higher education, buying a home, or simply getting credit to start a family.
No matter what type of loan that you feel is the best fit for your needs, you should always get quotes from several lenders. While the amount you need to borrow will likely not change, the amount that you are offered and the interest rate that comes with the loan will. Find the cheapest loan that fits into your timeline and choose that one.
There’s no need to pay extra interest on a loan, especially for larger purchases like homes or cars, since it can add up to thousands of dollars by the end of the loan.
Don’t Choose the First Loan You Find
Now that you know the difference between an unsecured vs secured loan, you can begin shopping around. There are tons of comparison and aggregator sites online that allow you to look at different lenders.
Don’t be afraid to compare traditional lenders, like banks and credit unions, against online lenders that don’t have physical locations. Of course, you should be aware of scams, but keep in mind that every lender designs their loans to meet different needs. If you have a low credit score and need money immediately for an emergency, online lenders may be a good idea.
For more information about lending and borrowing, and personal finance more generally, check out the finance section on our blog.