The difference between unsecured and secured loans, and which option is right for you
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- Unsecured personal loans and credit cards don't require any collateral, but they may be more difficult to qualify for.
- Secured loans and lines of credit, like a mortgage or auto loan, require you to pledge an asset as collateral, but they often come with looser requirements.
- Before you borrow money, take time to explore both secured and unsecured options to see which might work best for your needs.
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Consumers who need to borrow money have a wide range of loan options to consider. However, all loans, lines of credit, and other financing methods fall into one of two categories - unsecured or secured debts.
While both secured and unsecured loans and lines of credit could help you reach your goals, there is one main factor that sets them apart. Where secured loans require collateral, unsecured financing methods don't require any collateral at all.
What is an unsecured loan?
Unsecured loans and financial products can come in many different forms, but the underlying premise and agreement is the same. Consumers are not required to put down any of their assets to obtain an unsecured loan, but they do have to agree to repay the monies they borrow - plus interest, of course.
Without any collateral requirement at the beginning of the loan, it shouldn't surprise you that unsecured debts have more stringent requirements to qualify. You typically need good or excellent credit to qualify for unsecured loans with the best interest rates and loan terms. You also need to be able to illustrate your ability to repay and be able to prove you have a reasonable amount of liabilities compared to your income.
Unsecured debts can come in many forms, the most common being:
- Unsecured credit cards (the vast majority of credit cards)
- Most personal loans
- Student loans
Other debts that are considered unsecured include telephone and electric bills (and other utilities), court judgments, gym memberships, and even medical bills. Unsecured debts are any type of debt that is not secured by an asset.
Advantages of unsecured loans and lines of credit:
- When you apply for an unsecured loan or credit card, you won't have to put down a cash deposit as collateral.
- If you default on an unsecured debt, the bank won't be able to seize your assets.
- The application process is usually quick and painless. You can apply for unsecured personal loans and credit cards online and from the comfort of your home.
Disadvantages of unsecured loans and lines of credit:
- While the bank cannot seize your assets if you default on an unsecured debt, they can try to obtain a judgment against you. Defaulting on your loan will also result in severe damage to your credit score that may be difficult to overcome.
- Requirements for approval are tighter. You need good or excellent credit (usually a FICO score of 740+) and a solid work history to qualify for unsecured loans and credit cards with the best interest rates, terms, and perks. You may be able to qualify for some unsecured loans with fair credit, but you'll typically pay a higher interest rate and more fees.
- Interest rates tend to be higher on unsecured debts when compared to some types of secured debts.
What is a secured loan?
Secured debts are any type of debt that is held with an underlying form of collateral. This could be a cash deposit you put down, an automobile, your home, stock you own, or any other asset that has significant value.
While consumers who take on secured debt do agree to a repayment plan, the asset they used as collateral is on the line. If they default on their secured line of credit or secured loan, their collateral will be seized as a result.
Secured debts are typically considered lower-risk for the lender since they do have an asset to seize in the event the borrower stops making payments. For that reason, secured debts often have lower interest rates than unsecured alternatives.
Secured loans and lines of credit can work very differently depending on the type of secured debt you're dealing with. The most common types include:
- Secured credit cards
- Secured personal loans
- Home equity loans
- Home Equity Lines of Credit (HELOCs)
- Auto loans
While it makes sense that you would use your home as collateral for a mortgage or home equity loan and a car as collateral for a car loan, you may be wondering why anyone would borrow money if they are required to put down collateral. This is especially true when it comes to secured credit cards, since they require you to put down a cash deposit that is typically equal to your credit limit (e.g. you put down $500 to receive a credit limit of $500).
There are many reasons people apply for secured credit cards and loans, including the fact that credit requirements aren't as stringent. For people with bad credit, secured credit cards may be the only type of card they can qualify for. And, if you can't get approved for an unsecured credit card or loan, going with a secured option can be smart since it can help you build your credit score over time.
For example, the Capital One Secured Mastercard is available to consumers with limited credit histories and low credit scores who can put down up to $200 to receive a credit line of $200. While that limit is probably lower than most people wish it was, this card does report your credit movements to all three credit reporting agencies - Experian, Equifax, and TransUnion. You may also be able to secure a higher credit limit after making five on-time monthly payments. Plus, there's no annual fee.
With the Capital One Secured Mastercard, a consumer would have the opportunity to build credit when they wouldn't otherwise be able to. So, even though putting down a cash deposit isn't ideal, it's a smart move in the long run.
Advantages of secured loans and lines of credit:
- You may be able to qualify with poor credit or a limited credit history.
- Many secured loan options (HELOCs, home equity loans, mortgages, and auto loans) come with low interest rates and fair terms since they're secured by collateral.
- Putting down collateral may let you borrow more money than you could qualify for otherwise.
- Secured loans can help you build credit.
Disadvantages of secured loans and lines of credit:
- Secured credit cards tend to come with high interest rates and fees.
- If you default on a secured loan, your assets will be seized. Failing to repay a mortgage, home equity loan, or HELOC will ultimately lead to foreclosure, and failing to repay your car loan will lead to the repossession of your car.
- Many unsecured loan options, such as mortgages and home equity loans, have a time-consuming application process.
- As with any other loan, failing to repay the money you borrow can cause damage to your credit score and overall credit health.
The bottom line
Before you borrow money, take out a line of credit, or apply for a credit card, make sure you know the difference between secured and unsecured debts. While either one can help you reach your goals, the presence or absence of collateral is an important consideration that should be decided ahead of time.
Whatever you do, take the time to compare loan options and read the fine print before you sign on the dotted line for any type of loan. If there are any unsavory terms and conditions to be found, they will be tucked away in the fine print.
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