Loans are classified into two types: unsecured personal loan and secured. CNBC Select deconstructs both, explaining the benefits and drawbacks of each, as well as what assets can be used as collateral.
Let’s look at the differences between unsecured personal loan vs. secured loans, the benefits and drawbacks of each, and which one might be best for you.
- Learn about the difference between unsecured personal loan vs. secured
- Which Loan Type Is Best for You?
- How do unsecured personal loan vs. secured loans work?
What Is a Secured Loan?
A secured loan requires collateral as insurance in the event that you are unable to pay back the loan. Collateral is taken in the event that secured debt is not paid back. Lenders may also sue you for unpaid debt, begin debt collection, and seize collateral in addition to filing negative credit information on your report. Because of this, secured loans are typically riskier for the borrower.
In contrast, collateral reduces lenders’ risk, particularly when lending to borrowers with weak credit histories or low creditworthiness. Lenders may be more willing to be flexible with interest rates and borrowing limits when there is less risk involved.
What is an unsecured loan?
An unsecured loan does not require collateral, but you will still be charged interest and fees. Unsecured loans include student loans, personal loans, and credit cards.
Because there is no collateral, financial institutions make unsecured loans based in large part on your credit score and repayment history. As a result, unsecured loans may (but do not always) have higher interest rates than secured loans.
Advantages and Disadvantages of secure loan
When deciding on the type of loan you require, it is critical to weigh the benefits and drawbacks of each.
Secured loans have advantages in terms of repayment, interest, and borrowing amount, but they also have disadvantages in terms of borrower risk and use restrictions.
- Higher borrowing limits
- Less risk for lenders means lower interest rates for borrowers.
- A longer repayment periods
- Tax breaks for interest paid on certain loans (e.g., a mortgage)
- Risky to the borrower (potential for loss of collateral like home, car, stocks, or bonds)
- Particularly for the intended purpose (e.g., a home, but home equity loans are an exception)
Advantages and disadvantage of Unsecured Loans
Unsecured loans can benefit borrowers in terms of risk and time, but they can be disadvantageous in terms of interest rates and more stringent requirements.
- Less risky for the borrower
- Useful loan if you don’t have any property to use as collateral.
- A faster application process than for a secured loan (e.g., a credit card)
- Riskier for lenders usually means higher interest rates for borrowers.
- Difficult to qualify for it if you have bad credit or inconsistent income (you can qualify with a cosigner)
The difference between unsecured personal loan vs. secured
The primary distinction between secured and unsecured loans is that secured loans require collateral, whereas unsecured loans do not.
Unsecured loans are the more common type of personal loan, but interest rates can be higher because your creditworthiness only backs them.
How do secured loans work?
As part of the application process for a secured loan, you must provide collateral, such as your car or an investment account. Collateral can help you get a lower interest rate or a larger loan amount on a personal loan, but you risk losing your asset if you fail to repay the loan.
What you should know about secured loans:
Qualifying: Secured personal loans are typically easier to obtain than unsecured loans. A lender will look at your credit score, history, income, and debts, but adding collateral to your application can reduce the lender’s risk and increase its confidence in lending to you.
Rates: In general, secured loans have lower annual percentage rates than unsecured loans. Rates are determined using the same factors that lenders use to qualify you, so the value of your collateral can have an impact on your rate.
If you secure financing with a car, for example, the value of the vehicle influences whether you qualify and what interest rate you’ll receive.
Repayments: Secured personal loans are typically paid back in fixed monthly installments over a period of several years. Secured loans may have variable interest rates, which means that monthly payment amounts may vary.
Risk: There are two consequences for failing to repay a secured loan: Your credit will suffer as a result, and the lender may seize the collateral after only a few missed payments.
Even one missed payment can reduce your credit score by up to 100 points, and the impact will not be mitigated because it is a secured loan.
Where to get them: A secured loan can be obtained from a bank, credit union, or online lender, though banks and credit unions are the most common. These loans are typically secured by a savings or certificate of deposit account, which you will not be able to access until the loan is fully repaid.
Vehicles are typically required as collateral for secured loans offered by online lenders such as Oportun, Upgrade, and OneMain. Before lending to you, the lender may require an appraisal of the vehicle.
How do unsecured loans work?
An unsecured loan doesn’t need collateral, so your credit will be used to determine whether you are approved. In exchange for not running the risk of losing an asset, some borrowers may have to pay higher interest rates than they would with a secured loan.
What to know about unsecured loans
Qualifying: Borrowers with good to excellent credit (690 or higher FICO) have the best chances of qualifying for an unsecured loan. Lenders determine whether you qualify based on your credit score, history, and debt-to-income ratio. Some lenders look at additional information, such as your college education and where you live.
Rates: Fixed rates on unsecured loans typically range from 6% to 36%. Borrowers with the highest credit scores (689 or lower FICO) typically receive the lowest APRs, while those with fair or poor credit (689 or lower FICO) receive higher rates.
Repayments: Unsecured loans are repaid/paid back in fixed monthly installments, with repayment terms ranging from two to seven years.
Risk: Unsecured loans may be a safer option for some borrowers. Only your credit will be harmed if you fail to repay. If you are unable to make your monthly payments, some lenders will allow you to enroll in a hardship plan. These plans may include lowering or deferring your monthly payments.
If the loan is in default, which occurs between 30 and 90 days after you miss a payment, it may be sent to collections, and the collections agency may eventually take you to court.
Where to get them: Online lenders can offer low-interest rates as well as features such as quick funding and a completely online process.
Unsecured loans are not available from all banks; however, US Bank, PNC, and Wells Fargo are among the national banks that do. Banks may offer a lower rate if you are already a customer.
Which Loan Type Is Best for You?
After weighing the benefits and drawbacks of both loan types, it’s useful to know which one is best for specific circumstances. Here are some common scenarios in which one may be superior to the other.
- A secured loan: If you’re looking to make a large property purchase or don’t have the best credit, a secured loan may be the best option. If you do not already own other property, your purchasing property can be used as collateral. Furthermore, if you have poor credit, this loan may be more accessible and more advantageous with lower interest rates.
- An unsecured loan: If you have good credit and a steady income, an unsecured loan may be the best option. High creditworthiness enables you to meet stringent qualification criteria and may also enable you to obtain better interest rates (given that this type is characterized by higher interest).
Personal loans, both secured and unsecured, have distinct advantages and disadvantages. Secured personal loans typically have lower interest rates, but your collateral may be seized if you default. A lender cannot take your collateral with an unsecured personal loan unless a court orders it. However, you may be required to pay a higher interest rate.
Whether you choose a secured or unsecured personal loan, shop around with multiple lenders and compare their rates and fees to ensure you’re getting the best rates for your financial situation.
What happens if you don’t pay an unsecured loan?
Most lenders give late payments a grace period before reporting them to credit bureaus. However, if a loan is not paid on time, you can expect late fees or penalties, wage garnishment, and a drop in your credit score; even a single missed payment can result in a 40 to 80-point drop.
Are unsecured loans Safe?
Unsecured loans are safe as long as they are obtained from a bank, credit union, or reputable online lender that runs a credit check, fully discloses the fees and terms of the loan, and takes precautions to make sure the loan won’t put an undue strain on your finances. The risks are the likelihood that you will be able to repay the loan and how it will affect your credit.
Is it better to get a secured or unsecured loan?
Secured personal loans frequently have lower interest rates, but your collateral may be taken in the event of default. With an unsecured personal loan, the lender cannot take your collateral without a court’s approval. But the interest rate might be higher.
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