Is a Secured Loan a Good Option?
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. This type of loan generally has a lower interest rate because the bank has less risk since it can easily collect the collateral if you default on payments.
Types of Secured Loans
A secured loan can be a good way to build credit if you go through a reputable lender like a bank or credit union. Types include:
- 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 will 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.
The Good and Bad 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 are meant for those who have been denied unsecured loans. When used correctly, they can help build your credit score and credit history. Banks also like them because there is less risk involved. Lower interest rates are another advantage of choosing a secured loan.
While a secured loan is a great way to build your credit, 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.
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 puts your home or car at risk if you default on the loan in the future.
Instead, it's better to work on paying off your unsecured debt quickly. You may 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. 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 and adjust your living expenses, and 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.