Is a Secured Loan a Good Option?
If you need a little help smoothing your finances or getting out of a tough spot, you might be interested in getting a loan.
There are two main types of loans, secured and unsecured. A secured loan requires you to pledge an asset, such as your home, as collateral for the loan. In the event of missing a payment or defaulting on the loan, your bank or lender can then collect the collateral.
A secured loan might have a lower interest rate than an unsecured loan because the bank has less risk since it can easily collect the collateral if you default on payments. Here's what you need to know about secured loans.
Types of Secured Loans
There are different types of secured loans based on what's being used as collateral. Depending on the situation, a secured loan can help you make a large purchase you wouldn't be able to afford otherwise, or it might provide a way for you to solve a temporary cash-flow issue.
Additionally, a secured loan can be a good way to build credit if you go through a reputable lender like a bank or credit union. Here are some of the more common types of secured loans:
- Mortgages: Secured because your home acts as collateral for the loan. If you miss payments, you can go into foreclosure and lose your home.
- Car loans: The car itself is collateral for the loan. If you default on payments, the car can then be repossessed.
- Secured credit cards: The bank will usually require you to make a deposit against the card’s limit, which guarantees the loan. Banks might do this for customers who are trying to build their credit history, or for those trying to improve bad credit.
- Title loan: This is when you use a paid-off vehicle as collateral for another loan. Generally, these loans have high interest rates.
- Other secured loans: In some cases, you might be able to secure a loan with another asset. You might be able to use a valuable piece of artwork or jewelry. Some banks and credit unions might also issue a loan based on the value of a CD you have with the bank.
Pros and Cons of Secured Loans
When choosing a secured loan, carefully consider what you will use as collateral. In addition, ensure you are able to make payments in full and in a timely fashion, so you don't lose the asset.
Generally, secured loans (other than mortgages and car loans) are meant for those who have been denied unsecured loans. When used correctly, they can help build your credit score and credit history.
Banks might also like them because there is less risk involved. After all, if you don't make your payments, the bank has a right to the asset you've used as collateral. The bank can, in turn, use that collateral to offset its losses.
While a secured loan can be a great way to build your credit in some cases, it is also important to make all payments on time to improve your score. The more debt you take on, the harder this can become. If you overextend yourself, the plan can backfire.
Potentially lower interest rate
Qualify even if you're denied for other loans
Help you build or rebuild your credit
Potential to lose the asset
Some secured loans, like title loans, have high rates
Could turn unsecured debt into secured debt
Transferring Unsecured Debt to Secured Loans
If you have unsecured debt, avoid the temptation to transfer it into a secured loan. For example, many people take out a second mortgage to pay off their credit cards or take out a title loan on their car to pay off other bills. This can be dangerous, as it puts your home or car at risk if you default on the loan in the future.
Some of your assets, like your home, are likely to be protected from creditors seeking repayment for unsecured debt, but these protections vary state-to-state. If you secure your credit card or personal loans with your home, you could lose the house if you get in over your head.
Rather than turning unsecured debt into secured debt, it might be better to work on paying off your unsecured debt quickly. You might consider selling items you have or take on a second job to pay off debt as quickly as possible.
Manage Your Borrowing
Keeping your unsecured debt as-is while you pay it off will protect you (and your assets) in the long run—even if it seems like you will be paying off debt forever.
If you're hoping to tackle credit card debt, a credit union or a smaller bank may be willing to give you an unsecured personal loan to help you lower the interest rate on your credit cards.
It is important to carefully consider the financial aspect of any loan before borrowing. Many people simply think about the amount of the monthly payment, but if you want to buy a home or refinance soon, consider how this affects your total debt-to-income ratio, as well as the limits the monthly payment will place on your ability to save.
If you find yourself in a situation where you are struggling to make your monthly payments, then your best bet is not to borrow any more money, review your financial situation and adjust your living expenses, putting the focus on getting out of debt. A good budget can also help you get control of your money and see areas where you can cut back on your spending.
A secured loan can make sense in a number of situations. Many people can't buy a home or car without the help of a loan. However, before you buy, make sure you can afford the payments.
Additionally, secured loans can help you build your credit history or repair bad credit faster. While this can be an advantage, you also need to carefully consider whether you can repay the loan and whether you can lose the asset you're using as collateral. In the end, the ultimate goal should be to rely as little as possible on debt.
National Credit Union Administration. "Personal Loans: Secured vs. Unsecured." Accessed Feb. 6, 2020.
Federal Deposit Insurance Corporation. "Risk Management Examination Manual of Credit Card Activities Chapter II." Page 13. Accessed Feb. 6, 2020.
Consumer Financial Protection Bureau. "Differentiating Between Secured and Unsecured Loan." Page 2. Accessed Feb. 6, 2020.