There are two different types of loans: secured loans and unsecured loans. Understanding the differences between the two is an important step in achieving financial literacy, and can have a long-term effect on your financial health.
Basically, a secured loan requires borrowers to offer collateral, while an unsecured loan does not. This difference affects your interest rate, borrowing limit, and repayment terms.
There are pros and cons to choosing a secured vs an unsecured loan, which is why our partners at GreenPath have highlighted the differences for you here:
Secured loans are protected by an asset. The item purchased, such as a home or a car, can be used as collateral. The lender will hold the deed or title until the loan is paid in full. Other items can be used to back a loan too. This includes stocks, bonds, or personal property.
Secured loans are the most common way to borrow large amounts of money. A lender is only going to loan a large sum with a promise that it will be repaid. Putting your home on the line is a way to make sure you will do all you can to repay the loan.
Secured loans are not just for new purchases. Secured loans can also be home equity loans or home equity lines of credit. These are based on the current value of your home minus the amount still owed. These loans use your home as collateral.
A secured loan means you are providing security that your loan will be repaid. The risk is if you can’t repay a secured loan, the lender can sell your collateral to pay off the loan.
Advantages of Secured Loans:
- Lower Rates
- Higher Borrowing Limits
- Longer Repayment Terms
Examples of Secured Loans:
- Mortgage – A mortgage is a loan to pay for a home. Your monthly mortgage payments will consist of the principal and interest, plus taxes and insurance.
- Home Equity Line of Credit – A home equity loan or line of credit (HELOC) allows you to borrow money using your home’s equity as collateral.
- Auto Loan – An auto loan is an auto financing option you can obtain through the dealer, a bank, or credit union.
- Boat Loan – A boat loan is a loan to pay for a boat. Similar to an auto loan, a boat loan involves a monthly payment and interest rate that is determined by a variety of factors.
- Recreational Vehicle Loan – A recreational vehicle loan is a loan to pay for a motorhome. It may also cover a travel trailer.
Unsecured loans are the reverse of secured loans. They include things like credit cards, student loans, or personal (signature) loans. Lenders take more of a risk by making this loan, because there is no asset to recover in case of default. This is why the interest rates are higher. If you’re turned down for unsecured credit, you may still be able to obtain secured loans. But you must have something of value that can be used as collateral.
An unsecured lender believes that you can repay the loan because of your financial resources. You will be judged based on the five C’s of credit:
- Character – can include credit score, employment history, and references
- Capacity – income and current debt
- Capital – money in savings or investment accounts
- Collateral – personal assets offered as collateral, like a home or car
- Conditions – the terms of the loan
These are yardsticks used to assess a borrower’s ability to repay the debt, and can include the borrower’s situation as well as general economic factors.
Note that the five C’s of credit are different for personal loans vs. business loans.
Examples of Unsecured Loans:
- Credit Cards – There are different types of credit cards, but general credit cards bill once a month and charge interest if you do not pay the balance in full.
- Personal (Signature) Loans – These loans can be used for many purposes, and can vary from a few hundred to tens of thousands of dollars.
- Personal Lines of Credit – Similar to a credit card, a personal line of credit has an approved limit that you can use as needed. You can use this line of credit for almost anything, and you are only charged interest on the amount you spend.
- Student Loans – Student loans are used to pay for college and are available through both the Department of Education and private lenders. Although it is an unsecured loan, tax returns can be garnished to pay unpaid student loans.
- Some Home Improvement Loans
Making the Best Financial Decision
Knowing how and when to borrow money can be a challenge, especially if you already face financial challenges. If you are having trouble keeping up with all your bills, it might help to talk with someone. GreenPath offers free consultations and guidance to HUECU members to help manage debt, save money, and meet financial goals.