What is the difference between a secured loan and an unsecured loan?
Throughout life, many people will need to take out a loan of some kind. From home and auto loans to personal loans to business loans, lending is an age-old way of getting through hard times, making major purchases or getting a business up and running. Since the concept of lending has been around for such a long time, it has created a wide variety of loans with a dizzying array of variables ranging from interest rates to terms of the loan. Here is a brief overview of two types of loans: secured and unsecured.
How Secured Loans Work
A secured loan is generally secured by some type of collateral. Home and auto loans are considered a form of secured loan, because technically the bank owns your home or car until you pay it off, at which time you officially and fully become the owner. This is also true of boat loans, motorcycle loans or any type of loan you take out to purchase a single high-value item.
The problem with this type of loan is that you are still responsible for all upkeep and maintenance on the home, car, boat or motorcycle even though you are not technically the owner. The upside, however, is that you get to live in the home, drive the car etc., until you pay it off. Another downside, however, is that the bank will generally demand that you carry more insurance, which they can do, since they own the property, not you, and they get to set the terms of the loan. They, of course, want to protect their investment to the utmost, but you have to pay for it.
One benefit of secured loans is that you will most often be offered a significantly lower interest rate on a secured loan versus an unsecured loan. Since the bank has a means of recouping some, if not all, of its losses if you default on the loan, secured loans are less risky. While it is easier to get a secured loan even with a poor credit history, you will most likely end up paying a higher interest rate than someone with a good credit history. If the bank isn't sure it's going to get it's money back, they charge a high interest rate because the majority of your initial payments will go more towards interest than principle. This means they make the most money on the front end of the loan, rather than the back end.
In addition, if you default on a secured loan, the lender is entitled to take your home, car or other collateral and you get nothing. If you bought a $30,000 car and make $28,000 in payments on the car before defaulting, the bank will take your car, sell it and keep the profits. The same is true of your home or anything else you purchase through a secured loan.
Secured loans are not just issued by banks and you can get a secured loan on almost anything you have that is of value. If you take a TV or camera to a pawn shop, they essentially give you a loan on the item, which you can get back if you pay back the loan in addition to a set finance charge. This finance charge will often be high, however, and they will generally only loan you a fraction of the amount of what the item is worth because if you default on the loan, they still have to sell the item, which they may or may not be able to do. Not to mention, they don't lend out of charity, so obviously they are looking to make a profit. IF they don't make the profit by you paying back the loan and the additional finance charge, then they need to make the profit by selling the item for more than they loaned you. If you don't pay the loan back, they keep the item and sell it to someone else.
Payday and check loans are also a form of secured loan, because you are securing the loan with your paycheck or bank account. You can also get car collateral loans by using the title to your car for collateral. Unlike pawn shops, you can still drive your car while you are paying back the loan, but if you don't pay the loan back, the lender can still take your car.
PROS AND CONS
- Lower interest rates
- Can still get a loan with lower credit
- If you default on the loan, the bank gets it all
- Have to carry more insurance
Unsecured loans are loans which do not require any form of collateral. Credit cards are a form of unsecured loan, because you are being loaned money to make purchases or even take out a cash advance, but the bank or creditor doesn't have anything to take if you default on the loan. If you don't make your credit card payments, the bank can't come and pick up the TV you bought with it or take back the groceries you used your credit card to buy.
Personal or signature loans are also a form of unsecured loans and while they will often have a higher interest rate than secured home or auto loans, they will generally cost you less than pawn shop or car collateral loans. However, since the bank has no collateral to take to recoup its losses if you default on the loan, unsecured loans are much harder to get than a secured loan. While you can often get a home or auto loan with a moderate to even low credit score, a spotty or even new credit history and even a spotty job history, you will be unlikely to get an unsecured loan without a high credit score, a strong credit history and a stable job and living situation.
While unsecured personal loans will generally carry a higher interest rate than a secured home or auto loan, they will often carry a lower interest rate than a credit card, depending on factors like your credit score and stable work history. If you have excellent credit, you can get an unsecured credit card with an interest rate as low as 10-15% interest, which is still not as good as the 3-4% interest you can get on a home loan and the 0% interest you can probably get on an auto loan. It is still far less, however, than the 25% interest you will most likely pay on a credit card if you have poor credit.
In addition to credit cards, unsecured personal loans are often issued by banks in the form of funds deposited directly into your account. Like a home or auto loan, these are paid back via a set series of monthly payments for a set term, such as 12, 24 or 36 months. If you have good credit, you may be able to get an unsecured personal loan at a lower interest rate than a credit card. Not only will taking out an unsecured loan boost your credit score, but it may save you money over making a major purchase on a credit card.
Credit cards also have variable interest rates, while personal loans do not. You may make a large purchase when the interest rate on your credit card is at 12% only to have your bank or creditor raise your rates to 18% a few months later. The increased interest rate will apply to any balance you carry. If you take out a personal loan at a 12% interest rate, that interest rate will remain in effect until the loan is paid off.
PROS AND CONS
- Can use loan for whatever you want
- Bank can't take anything if you default on loan
- Higher interest rates
- Generally have to have better credit and stable history to get a loan