When you take out a loan, the lender may allow you to borrow the money with only your promise to pay it back, or the lender may require that you use an asset as security for the loan. For example, if you take out a loan to buy a car, the car serves as collateral for the loan, so if you stop paying on the loan, the lender can seize your car and sell it to pay off your loan. Learn more about the differences between secured and unsecured loans.
What's the Difference Between Secured Loans and Unsecured Loans?
|Secured Loan||Unsecured Loan|
|Secured by collateral||Not secured by collateral|
|Typically have lower interest rates||Typically have higher interest rates|
|Typically available in higher amounts||Typically available in lower amounts|
Secured loans are loans that are backed by an asset, like a house in the case of a mortgage or a car with an auto loan. This asset is the collateral for the loan. When you agree to the loan, you agree that the lender can repossess the collateral if you don't repay the loan as agreed.
Even though lenders repossess property for defaulted secured loans, you could still end up owing money on the loan if you default. When lenders repossess property, they sell it and use the proceeds to pay off the loan. If the property doesn't sell for enough money to cover the loan completely, you will be responsible for paying the difference.
The same isn't true for an unsecured loan, which is not tied to any of your assets, and the lender can't automatically seize your property as payment for the loan. Personal loans and student loans are examples of unsecured loans because these are not tied to any asset that the lender can take if you default on your loan payments. However, lenders can take other measures if you default, including suing you for not paying and potentially garnishing your wages.
You typically need a good credit history and a solid income to be approved for an unsecured loan. Loan amounts may be smaller since the lender doesn't have any collateral to seize if you default on payments.
Secured loans typically have lower interest rates than unsecured loans. Secured loans are less of a risk to lenders since the collateral can be seized and sold if the borrower defaults. Unsecured loans have higher interest rates since they're a higher risk to lenders.
Secured loans may allow borrowers to get approved for higher loan limits. For example, mortgages are available for $1 million or more. Of course, even though you may qualify for a larger loan, you still must be careful to choose a loan that you can afford.
Unsecured loans are typically lower than secured loans, but there are exceptions. The median student loan debt for medical school, for example, was $200,000 in 2019.
How They Impact Your Credit
Lenders can (and do) report the payment history of both types of loans to the credit bureaus. Late payments and defaults with both types of loans can be listed on your credit report.
With secured loans, the lender may use foreclosure or repossession to take the asset tied to the loan. These may result in additional negative entries being added to your credit report.
Which Is Right for You?
With the risk of having your property seized if you don't repay the loan, you might wonder why anyone would choose a secured loan. People sometimes choose secured loans because their credit history will not allow them to get approved for an unsecured loan.
With some loans, such as a mortgage or auto loan, the lender won't approve your application unless they have permission to take possession of the property if you default. Some loans are secured by design, including title loans and pawn loans.
Securing the loan with collateral also affects your ability to switch out the collateral if you need to, and it usually requires additional insurance. For example, you'd typically have to use any insurance proceeds to fix the car, even if it still runs fine, you have an auto loan that's secured by your car and the car is damaged in an accident. You could use the money as you see fit if the same loan was unsecured. The lender wants to make sure their collateral is protected.
The Bottom Line
Whether a secured or unsecured loan is best for you depends on the reason you're taking out the loan and your financial situation. Secured loans typically have lower interest rates, but your loan is secured by your assets. Unsecured loans usually have higher interest rates and aren't tied to collateral. Regardless of the type of loan, pay attention to the interest rate, repayment period, and monthly payment amount.