How do secured loans work?
If you want to borrow money, chances are you’ve already started scoping out options that could work for you. Loans are a popular choice for many consumers, and they come in two forms – secured and unsecured. But the differences between the two aren’t always clear.
In short, secured loans require collateral while unsecured loans do not. You’ll also find that secured loans are far easier to qualify for and generally have lower interest rates as they pose less risk to the lender.
Still, they may not be the best option for you and could have serious consequences for your credit and finances if you’re unable to repay what you borrow.
What is a secured loan and how does it work?
Secured loans are debt products that are protected by collateral. This means that when you apply for a secured loan, the lender will want to know which of your assets you plan to use to back the loan. The lender will then place a lien on that asset until the loan is repaid in full. If you default on the loan, the lender can claim the collateral and sell it to recoup the loss.
It is important to know precisely what you are promising and what you stand to lose before you take out a secured loan.
Secured loan vs. unsecured loan
Some loans, such as personal loans, can be either unsecured or secured, depending on the lender. If you don’t qualify for the unsecured option or you’re looking for the lowest possible interest rate, check to see if the lender offers a secured option for the loan you’re interested in.
When it comes to choosing a secured versus an unsecured loan, there are multiple factors to consider. Here are a few key differences between the two, along with benefits and drawbacks of each loan to consider.
|Secured loan||Unsecured loan|
|Availability||Must have an asset to use as collateral||Collateral not required /td>|
|Borrowing limits||Lower borrowing limits that may not be sufficient for your funding needs||Higher borrowing limits if you’re putting up collateral that’s worth a sizable amount|
|Credit score||Credit score and financial health will determine eligibility, but they could be more accessible if you have bad credit||Credit score and financial health will determine eligibility, but you’ll generally need good or excellent credit to qualify for the most competitive loan terms|
|Eligibility criteria||Less stringent since the lender assumes lower risk||More stringent since the lender has no rights to the collateral if you default on the loan|
|Interest rates||Typically lower||Typically higher since the lender is unable to recoup their losses if you fall behind on payments|
|Penalties||Collateral can be seized, credit score will drop||Missed payments will enter into collections, credit score will drop|
|Loan types||Mortgages, HELOCs, auto loans, business and secured credit cards, etc.||Unsecured credit cards, student loans, personal loans, etc.|
Types of secured loans
Lenders want to know that they have leverage once you walk away with their money. When they place a lien on your collateral, they know that in a worst-case scenario, they can take possession of the assets you’re using as collateral. This does not guarantee that you will repay your loan, but it does give lenders a greater sense of security and gives the borrower more impetus to repay the loan.
Types of loans that are secured include:
- Mortgage: With a mortgage, you put your home or property up as collateral to buy that home. If you fail to make the payments, your home can be foreclosed on.
- Home equity line of credit: A home equity line of credit (HELOC) gives you access to your home equity in the form of a credit line, like a credit card. With a HELOC, you also put your home up as collateral.
- Auto loans: When taking out a loan to pay for a car or any other vehicle, your vehicle will be used as collateral. If you don’t make the payments on time and in full, your vehicle could be seized.
- Loan for land: A land loan is used to finance the purchase of land. This type of loan uses the land itself as collateral.
- Business loan: Business loans can be used to buy equipment, pay wages or invest in business projects. When you take out a business loan, there are a number of things you can use as collateral. For example, inventory, equipment or your land or building can be used to secure a business loan.
What types of collateral are used to back a secured loan?
Secured loans are usually the best way — and often the only way — to obtain large amounts of money. Nearly anything can be accepted as collateral, as long as it is allowed by law. Lenders prefer assets that are easy to collect and can be readily turned into cash. What you use as collateral likely will depend on whether your loan is for personal or business use. Examples of collateral include:
- Real estate, including equity in your home.
- Cash accounts (retirement accounts typically do not qualify).
- Cars or other vehicles.
- Machinery and equipment.
- Insurance policies.
- Valuables and collectibles.
How do I apply for a secured loan?
When it comes to getting a secured loan, take these steps before applying:
- Check your credit: Before applying for a loan, you’ll want to check your credit report. Whether you’ll get approved for the loan is largely based on your creditworthiness, and while secured loans may have less stringent credit requirements than unsecured loans, it’s still important to know your credit score for qualification. You can check each of your credit reports for free every 12 months (or weekly through December 31, 2022) with AnnualCreditReport.com.
- Check the value of your assets: The value of the asset you want to use as collateral will usually determine how much you can borrow with a secured loan, so get an appraisal or look up estimated resale value before researching lenders.
- Shop around with different lenders: Shopping around allows you to compare lenders’ rates and fees. Many lenders provide prequalification, which lets you see what you’re eligible for with no impact to your credit. It’s usually best to get prequalified with at least three lenders.
- Apply for the loan with the most competitive lender: If you’re applying with an online lender, the entire process can typically be done online. If you’re applying at a bank or credit union, you might have to visit a physical location.
What happens if you default on a secured loan?
After a few missed payments on a secured loan, the lender is likely to repossess the asset used to secure the loan. In many states, the lender is not required to give you notice of the repossession. To make matters worse, repossession is not the end of the matter. If the repossessed asset does not sell for enough to cover the amount of your loan, you are responsible for the difference.
For example, if you owe $20,000 when you stop making payments on a boat loan and the boat is repossessed and sold for $15,000, you will owe the lender the outstanding $5,000 and any outstanding fees. The repossession stays on your credit report for seven years.
If you miss payments on a mortgage, home equity loan or business loan, the lender has a lengthier process to recoup its money. In about half of the states in the U.S., a lender must go to court to foreclose on a property. In the other half, the lender is required to provide you with advance notice of foreclosure. In either case, it is a good idea to call your lender as soon as you know that you will be missing payments to see if you can negotiate a loan modification that will allow you to keep your home or business.
If you’re interested in a secured loan, start by checking your credit so you’ll know where you stand and if you’re likely to qualify for the best competitive interest rates. Next, research reputable lenders, and get pre-qualified to view rate quotes with no impact to your credit score.
Once the loan is approved, submit a formal application. It’s also ideal to rework your budget before the loan is funded to ensure you don’t fall behind on loan payments and possibly lose your collateral.
While secured loans do present more risks than unsecured loans, they can be helpful tools as long as you keep up with the monthly payments.