Secured vs. Unsecured Loans: What You Need to Know

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What's the difference between a secured and an unsecured loan? Simple: A secured loan uses collateral—a piece of your property that has monetary value and can act as security—to protect a lender from loss if you fail to repay a loan. Home loans and car loans are two common examples. Unsecured loans don't rely on collateral. Though they reduce some risk for borrowers, they usually come with higher interest rates and shorter payoff terms.

Choosing between secured and unsecured loans often comes down to what your available options are and whether you can save money overall with one choice or another. For many, a lifetime of credit and loans will include both secured and unsecured debt. The trick is figuring out which type to use for any given situation.

What Is a Secured Loan?

To understand how a secured loan works, think of a typical auto loan. In exchange for the money you need to purchase a car, the lender uses collateral—in this case your new car—as a form of security. If you fail to make your loan payments, the lender can repossess your car, sell it and use the proceeds to help pay off your debt.

Mortgages and home equity loans use your home as collateral. Secured credit cards and personal loans require a cash deposit. Title loans let you use collateral—often the equity in your car—to borrow money. What all of these loans have in common is the lender's ability to take possession of valuable property you've pledged if you don't pay your loan as agreed.

The upside for you, the borrower, is access to credit. Without collateral, you might not be able to borrow hundreds of thousands of dollars to buy a home. Because secured loans are considered less risky, interest rates are often lower than they would be without collateral. In the case of secured credit cards and loans, making a cash deposit upfront might allow you the opportunity to build credit when unsecured credit is not an option.

What Happens if You Default on a Secured Loan?

If you make your payments on time, your collateral remains yours. But if you stop making payments and default on your secured loan, the lender has the right—per your agreement—to take possession of your collateral.

Whenever you take out a secured loan or line of credit, review your agreement carefully. Being a few weeks—or even a few days—late on a mortgage payment may result in a late fee, but it generally won't trigger a foreclosure. What you want to know is how soon a foreclosure could happen. Learn the same for any auto loan or any other secured loan you may have.

Defaulting on a secured loan carries the same credit consequences as defaulting on an unsecured loan: It can negatively affect your credit history and credit score for up to seven years. However, with a secured loan, the bad news doesn't end there. You may also lose your home or car. You may forfeit any cash deposit you've put up as collateral. And if the proceeds from the sale of your home, car or other collateral don't cover your entire debt, you may be on the hook for the remaining balance.

What Is an Unsecured Loan?

Unsecured loans don't involve any collateral. Common examples include credit cards, personal loans and student loans. Here, the only assurance a lender has that you will repay the debt is your creditworthiness and your word. For that reason, unsecured loans are considered a higher risk for lenders.

You'll generally need a strong credit history and a higher score to qualify for an unsecured loan. Unsecured loans typically come with higher interest rates as well: Think of the difference between the average mortgage rate and what you might pay annually on a credit card. But with an unsecured loan, you aren't risking any collateral—and that may counterbalance some of the additional risk you shoulder when you take on high-interest debt that will be more difficult to pay off.

What Happens if You Default on an Unsecured Loan?

Failing to repay any debt will have a negative effect on your credit. Although you don't have to worry about losing your collateral with an unsecured loan, the cascading effects of falling behind in your payments can do real damage to your credit—and your finances.

Late payments made 30 days or more past the due date will lower your credit score and remain on your credit report for seven years. If a lender puts your account into collections or takes legal action against you, this information also becomes part of your credit history. Collections and civil judgments remain on your credit report for seven years from the date the account first went delinquent or from the date a ruling was made against you. Serious delinquencies are a red flag to future lenders, who will think twice before extending credit to you.

Which Type of Loan Is Right for You?

As a rule, secured loans will allow you to borrow more money at lower rates, but they put your property at risk if you fail to pay. Unsecured loans don't put your property at risk, but they can be more difficult to get and you'll generally pay more interest.

Sometimes the choice between a secured and an unsecured loan is not really yours to make. Mortgages and car loans are always secured, for example. If you don't yet have the credit history and score to get approved for an unsecured credit card, starting with a secured credit card can help you build credit.

But what if you're planning a minor bathroom remodel or another small project? Choosing in this case can be a bit more complicated. Should you use a home equity line of credit (HELOC) to pay for it or finance it using an unsecured personal loan? The best way to decide is to do the math: Compare interest rates, fees and repayment requirements. Keep in mind that while the HELOC is riskier, it also gives you the opportunity to borrow only what you need, unlike a personal loan where you take out a specific amount and have to pay back that amount regardless of whether you needed the whole thing for your remodel. That said, if savings are nominal, or you don't want to put up your house as collateral, a personal loan may be best.

How Do Secured and Unsecured Loans Affect Your Credit?

Secured and unsecured loans impact your credit in much the same way. When you apply for the loan, the lender will check your credit score and report. Once you have the credit card or loan, they'll report your payment history, credit card limit and balance (and any negative information, such as collections, defaults, foreclosures or legal judgments), to one or more of the consumer credit companies: Experian, TransUnion and Equifax.

Paying your loan or credit card on time can help you build credit. And using secured or unsecured personal loans to consolidate credit card debt can improve your credit score by reducing your credit utilization. Curious about your results? You can use free credit monitoring to track your credit score and report and see precisely how you're doing—a good idea well before you complete your loan application as well.

Both secured and unsecured loans can play positive roles in your financial life. Together, they're the keys to homeownership, car purchases, responsible credit card use, financing your education and sometimes simply managing your money effectively. Borrow judiciously and pay your loans back in a timely manner; your credit will fare just fine.