With so many loans available, the whole space can be confusing - especially finding out what is the difference between secured and unsecured and how each type of loan works. While both types can give you access to money, they operate in different ways. Understanding the difference is fundamental in choosing the right type of loan. In this article, we will explain what a secured loan is, how it is different to an unsecured loan, and ultimately determine which type might be right for you.
Understanding Secured Loans
A secured loan is one in which you pledge an asset (known as collateral) to secure the loan. You can pledge almost anything as collateral for a loan—from your home or car to jewelry or art. If you fail to repay the loan, the lender has the right to seize the collateral to recover their money.
What is a Secured Loan? A secured loan is where the lender has some promise (in the form of an asset) that they can sell to get their money back if you don’t pay them back. This lowers the lender’s risk so their loan rates available to you are often lower than for unsecured loans. In Malaysia, for example, they make good amounts of money on secured personal loans and this loan type is relatively popular since borrowers can get some large loans at comparatively low-interest rates.
Secured loans can be used for anything from buying a house, investing into businesses, and even securing personal loans. The benefit of taking out a secured loan is that they usually have a higher borrowing limit and lower interest rates compared with unsecured loans.
Examples of Collateral
Depending on the type of loan, the asset you must pledge as collateral may vary. The most common forms of collateral include:
- Real estate: For mortgages or home equity loans, your home or property serves as collateral.
- Vehicles: In the case of an auto loan, the car or vehicle you buy is used as collateral.
- Valuables: Items like jewelry, collectibles and equipment can be used for some secured loans.
- Investments: Personal loans that are secured, like a secured personal loan, may use stocks, bonds, or other investment assets as collateral.
- Cash accounts: Some lenders allow you to pledge a cash deposit or savings account as collateral for a loan.
Providing collateral reduces the risk to the lender, which can lead to better loan terms, such as a reduced rate and potentially a greater loan amount.
How Secured Loans Work
Because secured loans work on the simple premise that if you fail to pay, the lender can take the collateral, the process works like this:
The Loan Process and Terms
For a secured loan, you will need to provide proof of ownership for the asset you intend to secure against the loan. Once the lender has assessed the collateral, and conducted a credit check, they will make you an offer, including the amount of the available loan and repayment terms as well as the secured loan rates they are willing to offer you.
When it comes to terms, which vary by loan type, these loans usually have longer repayment terms (terms range from a year out to 30 years.) For example, mortgages fall into the 20-30 year time span, while a secured personal loan might fall into 1-5 years. Interest rates are usually fixed, which means the rate is the same for the life of the loan.
Comparing Secured Loans to Unsecured Loans
Now that we know what a secured loan is, let’s compare it to an unsecured loan -– a loan that doesn’t require collateral. There are a lot of pros and cons to both types, and understanding their differences is key.
Secured Loan Example vs. Unsecured Loan
An example of a secured loan is a car loan, where the vehicle being purchased is—quite literally—a mortgage on the loan. If you fail to make payments, the lender can repossess the car to recoup the money owed. For that reason, car loans are among the easiest for consumers to obtain. An example of an unsecured loan is a cash loan; the lender takes on more risk, so these types of loans carry higher interest rates.
In the discussion around unsecured loan compared to secured loan, a few things to keep in mind are:
- Interest Rates - Secured loans tend to have more attractive interest rates since there is no unsecured risk to the lender.
- Loan Amount - You will usually be able to borrow more money since the loan is backed by collateral.
- Approval Process: Secured loans may be easier to qualify for, particularly for those with blemished credit. The collateral reduces the lender's risk.
- Repayment Terms: Secured loans tend to come with longer repayment terms, while unsecured loans may have shorter terms and higher payments.
If you find yourself in a dilemma over whether to take a secured or unsecured loan, being aware of these differences will help you choose which is right for you.
Secured loans — the good and the bad
There are benefits and drawbacks to any financial product: let’s see what you gain (and may lose) with a secured loan.
Benefits of Secured Loans
- Lower interest rates: Since the lender has collateral to work with, they face less risk and this is reflected in lower secured loan rates.
- Higher borrowing limits: You can sometimes borrow more than you’d be able to with an unsecured loan, due to the collateral involved.
- Easier to get approved for: If you have poor or fair credit, it may be easier to qualify for a secured loan since the lender has the collateral to help offset risk.
- More flexible loan terms: You may be able to borrow over a longer-term than if the loan were unsecured (for example, 30 years for a mortgage), and you may be able to obtain a fixed interest rate.
Cons of secured loans
- Risk losing what you pledge as collateral: If you default on the loan, you’ll have to forfeit the asset you pledged as collateral. This could include your home, your car or some other valuable asset.
- Size of loan depends on collateral: If you are using collateral to secure your loan, the amount of money you can borrow depends on your finances and the value of the collateral you are putting up. The lower the value of the collateral, the less likely the lender will be to loan you money.
- It may take longer to receive your funds: Because secured loans may be seen as a larger more complex loan, more paperwork may be needed. For example home loans will need property appraisals while car loans will not.
Secured loans, store leave you at risk of losing an asset that is important to you. It is necessarily worth carefully considering before going ahead with a loan.
What Happens if You Default on a Secured Loan?
Taking out a secured loan is risky because if you default on the loan, you stand to lose property pledged as collateral; that is, to lose your home, automobile, or other valuable property.
If you miss payments, or default on your loan, the lender can begin the process of claiming your collateral. For example, if you have a secured personal loan where your car serves as collateral, the lender could repossess your car if you don’t make the payments and you likely would still owe the lender money. For a mortgage, the bank could foreclose on your home.
But what if the asset will not sell for enough to pay off the debt? You may owe money on it even after the repossession or foreclosure, depending on the cash loan terms. The lender may sue you for the net amount owed and produce a deficiency judgment against you which damages your credit report.
What to Do if You can’t pay back a secured loan
If you’re unable to pay back a secured loan, keep asset loss at bay by doing any of the following:
- Contact your lender: A lot of lenders will work something out with you if you’re in a tight financial situation, whether that might come down to renegotiating the loan terms or going on a temporary forbearance plan.
- Get financial help: People in financial trouble can find help from many nonprofit organizations and financial counselors to impact debt and prevent default.
- Pay your bills in the right order: If you get really strapped for cash and must choose which bills to pay and which to ignore, always pay your secured creditors (that means your mortgage and car loan) first.
Practical Advice for Borrowers
Before taking out a secured loan, consider these practical steps:
- Determine whether you can repay: Examine your income, expenses, and the effect a loan payment will have on your budget.
- Compare lenders: As always, shopping around for the best rates and terms is important. Many such online marketplaces exist, like Bankrate, which can help you find the best secured personal loan for your needs.
- Consider alternatives: If you’d rather not put your assets at risk, consider an unsecured loan or other borrowing options.
Bottom Line
If you need to borrow a large sum of money and have assets available to put up as security, a secured loan could be a great option. You will enjoy a lower interest rate and a longer repayment period but do run the risk of losing your security if you fail to pay back the loan. An unsecured loan is, generally speaking, a more “safe” borrowing arrangement in terms of avoiding loss of assets but you may have to pay a higher interest rate and may have to meet stricter qualification guidelines.
Whether or not you’re looking for a secured personal loan, or trying to decide the pros and cons of unsecured loan vs secured loan, weigh the good and the bad, and then choose the path that best fits your budget and personal finances. A little bit of research goes a long way, and you’ll feel confident you made the right decision when it helps you meet your financial goals and still lets you sleep at night!
FAQ
How does a secured loan work?
For a secured loan, this is where you "borrow" money and return it with interest to a lender, using some asset as collateral. If you fail to repay, the lender seizes the asset. Terms of the loan state: how much you’re borrowing, how long you need to repay it and the rate of interest.
What collateral can I use for a secured loan?
Real estate (your home), vehicles (like your car or boat), cash accounts, equipment, and sometimes investments like stocks or bonds can all be used as collateral.
Can I get a secured loan with bad credit?
Yes, secured loans are often easier to qualify for if you have bad credit since the collateral reduces the risk for the lender.