Before you take out a personal loan, you should know there are two main types – secured and unsecured.
With an unsecured loan, you can borrow money without putting down any collateral. A secured personal loan, on the other hand, is backed up by an asset the bank can seize if you don’t repay — such as your car or home.
If you need to borrow money, understanding how these types of loans differ is key to choosing the best loan for your needs. Keep reading to learn how each loan type works, and which might be best for your situation.
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Understanding Unsecured Loans
Because unsecured loans don’t require collateral that can be repossessed in the event of a default, lenders rely on something else to protect themselves from delinquent borrowers – your credit score.
Typically speaking, unsecured loans are mostly available to individuals with good credit and a solid credit history. The other important detail to understand is how flexible unsecured loans are. Since they aren’t backed with collateral, you can take out an unsecured loan for any reason.
If you stop making the payments on your unsecured loan, your lender won’t have an asset – or collateral – to collect as an alternative form of repayment. Instead, they can place negative marks on your credit report and pursue repayment via a collections agency. If you still refuse to pay, your lender can even take you to court and sue you for your remaining balance interest and fees.
Benefits of an Unsecured Loan:
- You don’t have to put down collateral to qualify.
- Unsecured loans are readily available through online lenders and traditional banks and credit unions.
Drawbacks of Unsecured Loans:
- Since unsecured loans don’t require collateral, lenders tend to charge higher interest rates and fees to account for the greater risk.
- You usually need at least decent credit or better to qualify for an unsecured loan.
How Secured Personal Loans Work
We already mentioned that secured loans require collateral, but the type of collateral you put down depends on the type of loan. While loans can certainly vary, most lenders require collateral in the form of your home, your car, or your savings (for example, a certificate of deposit or savings account).
When people make large purchases like a home or a car, they often take out secured loans to do so. When you get a mortgage to buy a home, for example, your house serves as collateral — if you default on your mortgage, the lender can try to foreclose on the home to recover its losses. The same is true when you take out a auto loan to purchase a vehicle: Your loan is secured by the car you buy.
Other secured loans take place after a purchase is made. If you have equity in your home, for example — meaning it’s worth far more than what you owe on it — you can take out a home equity line of credit (HELOC) and use your home equity as collateral. Likewise, if you have some equity in your car, you can take out an auto title loan or auto equity loan and use your car as collateral. In both of those cases, the lender would hold the title to your car until the loan is repaid.
No matter which type of secured loan you choose, your lender can seize the asset you put down as collateral if you quit repaying your loan. In the case of a secured loan where your car is the collateral, the lender may send someone to repossess your vehicle. In the case of a secured home loan, they may proceed against you in court and begin the foreclosure process.
Benefits of a Secured Personal Loan:
- Since secured loans require collateral, banks may consider them lower risk and charge lower interest rates.
- Because the collateral lessens the lender’s risk, you may be able to qualify for a secured personal loan with fair or even poor credit.
Secured Loan Drawbacks:
- Offering an asset as collateral means you’re putting your own possessions on the line — and if you quit paying on your loan, your asset will be seized.
- You have to give up the title of your car or home until your loan is repaid if you’re using the asset as collateral.
Before You Consider a Personal Loan
When taking out either type of loan, it’s important to follow a few key rules. For starters, you should ask yourself if you need the additional money in the first place. Remember, every dollar you borrow will need to be paid back one day — with interest. If you bite off more than you can chew, you might live to regret it.
Second, you should shop around for the best interest rate and terms. Whether you prefer an unsecured or secured personal loan, the rates and loan terms you’ll find will vary. Always compare loans and make sure to read the fine print for “gotchas” and additional requirements. When it comes to loans, what you don’t know can hurt you.
Finally, consider loan alternatives that might be a better deal. If you only need money in the short term, for example, you may be better off signing up for a zero-interest or balance transfer credit card. With these offers, you can secure 0% interest on balance transfers and/or purchases for anywhere from 12 to 21 months. Better yet, you can apply for a credit card online – without visiting a bank or filling out long and complicated forms.
As always, however, you should read the fine print and understand any offer you’re considering before you sign up. Just like traditional loans, credit card issuers are in the business of making money. Once your 0% APR offer expires, you’ll need to pay interest on your balance.
If you need money fast, a secured or unsecured loan can make a lot of sense. Just make sure you know what you’re getting into before you sign on the dotted line. The best strategy with any loan is to shop around for the best deal, take your time, and weigh the pros and cons before you sign up.