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When shopping for a personal loan, you may be able to choose between a secured loan and an unsecured loan. The main difference between secured and unsecured loans is whether or not you need collateral in order to qualify. Before you make any decisions about signing for a loan, learn what else sets these two loan types apart.
Differences between secured and unsecured personal loans
- Secured loans are backed by collateral and unsecured loans are not.
- Interest rates tend to be lower on secured personal loans.
- There are more restrictions on what an unsecured loan can be used for.
- Secured loans often have higher borrowing limits.
- For borrowers with faulty credit, secured personal loans are easier to get.
What are secured loans?
A secured loan allows you to borrow a lump sum from a lender but requires you use some type of collateral in order to qualify. In the event you default on the loan, the lender can repossess the asset used to secure the loan in order to compensate for the unpaid loan funds.
The collateral requirement is the most fundamental difference between a secured and unsecured loan. A secured loan is backed by collateral — such as your home or car — that the lender places a lien on in case you don’t make your loan payments. Unsecured loans aren’t collateralized, which means your creditworthiness is the only thing backing the loan, and your assets are not at risk if you default.
Because the lender can recover at least some of its losses if you default on a secured loan, interest rates may be lower. For example, Navy Federal Credit Union, the largest credit union in the United States, offers a secured personal loan with an annual percentage rate that is at least 6% less than its unsecured loan.
“That means a secured loan, if you can qualify for one, is usually a smarter money management decision versus an unsecured loan,” says Katie Ross, education and development manager at American Consumer Credit Counseling in Auburndale, Massachusetts.
If you have poor or little credit, you may not be able to get an unsecured loan from most lenders, although some online marketplace lenders specialize in loans to borrowers with weak credit.
“A secured loan is normally easier to get, as there’s less risk to the lender,” Ross says. “If you have a poor credit history or you’re rebuilding credit, for example, lenders will be more likely to consider you for a secured loan versus an unsecured loan.”
Secured loan fees
Fees vary depending on the lender and may include an origination fee that is deducted from the loan funds. When using personal property to secure the loan, you may also need to pay for an appraisal.
Common types of secured loans
- Mortgage loans: When buying a house, these loans require the house to be used as collateral. If the borrower is unable to repay the loan, the house can go into foreclosure and the borrower can lose the house.
- Vehicle loans: These types of loans are available for cars, trucks, motorcycles and boats. The vehicle is used as collateral. Not repaying the loan can result in the vehicle being repossessed by the lender as repayment.
- Secured credit cards: For those with limited credit history, a secured credit card can offer the chance to build your credit score. The credit card requires a cash deposit to serve as collateral. If a monthly payment is not made, the money is taken from the cash being held as collateral.
What are unsecured loans?
An unsecured loan does not require any kind of collateral in order for you to qualify for loan funds. You’ll need a better credit score in order to qualify for an unsecured loan. The good news is that it also means you’ll probably get a lower interest rate, especially when comparing a secured versus unsecured loan.
Using unsecured loan funds
Most unsecured loans come with few restrictions on how the money will be used. As long as the loan proceeds aren’t going toward gambling, buying securities, illegal activities or, in some cases, college expenses, you’re free to spend the money as you please.
But lenders tend to approve secured personal loans for specific purposes, like buying a boat or a recreational vehicle.
“An unsecured loan is always going to be easier for the consumer to use,” says Todd Nelson, a senior vice president at LightStream, the online lending arm of SunTrust Bank.
There are some secured loans that can be used for multiple purposes. For those loans, you may be able to use your own savings as collateral.
When opting for an unsecured loan, you may not qualify for as much funds as you would with a secured loan. That’s because the lender takes on less risk when a loan is secured by collateral. If you have a good credit score, however, you may still qualify for better loan terms even with an unsecured vs. a secured loan.
Common types of unsecured loans
- Personal loan: These are often called “term loans” since they have a fixed period of time for repayment with monthly payments made in equal amounts.
- Revolving loan: These are loans that the borrower can use and repay repeatedly. Credit cards and personal lines of credit are examples of this type.
- Consolidation loan: When a borrower requests this type of loan from a financial institution, it is typically granted on the borrower’s signature.
Your credit may also play a role.
There is no interest rate advantage for someone with superb credit to take out a secured loan with LightStream, Nelson says.
“The rates are now as competitive or oftentimes more competitive than the secured product,” Nelson says.
Choosing an unsecured loan
A secured loan may have a lower interest rate and a higher borrowing cap, but there are times when an unsecured loan makes more sense, or it may be your only option.
If you don’t have any collateral to back a loan, for example, you won’t be able to take out a secured loan. And an unsecured loan may be the best choice for someone who doesn’t want to place their assets at risk in case of default. Loan rates do vary, and it is important to consider the rate before choosing an unsecured loan.