All loans fall into one of two categories: secured or unsecured. A secured loan requires some kind of collateral. An unsecured loan does not. Understanding the differences between these two types of loans will help you choose the right option for your needs.
To understand secured loans, you have to understand collateral. Collateral is defined as assets or property pledged by a borrower to protect the interests of the lender. That means your collateral is the lender’s guarantee of repayment.
What is a Secured Loan?
Secured loans are more common than you might think. Auto loans and mortgages are both classified as secure, because the car or house being bought is put up as a collateral asset. If you don’t make your payments, the lender will simply repossess the asset.
The primary benefit of a secured loan is that you can typically borrow higher amounts of money and pay a lower interest rate. The risk to the lender is minimal, so the terms are better. For the borrower, the risk is in losing the collateral asset. Here are two examples:
In the case of an automobile repossession, the lender will sell off the car and use the proceeds to help repay the debt. Unfortunately, automobiles start to depreciate the day you drive them off the lot, so you might still have a balance owed after the resale.
With home loans, you run the risk of foreclosure if you can’t make your payments. Chances are you will lose a percentage of your equity in this scenario. The bank won’t resell the property for maximum value, and you’ll be charged foreclosure fees.
You can also use what is known as a “hard asset” when asking for a secured loan. An expensive piece of jewelry or valuable work of art fall in this category. The lender can have it appraised, lend you money based on the appraised value, and hold the asset until you’re paid in full.
What is an Unsecured Loan?
If you’ve ever charged something to a credit card, you have essentially taken out an unsecured loan from the credit card issuer. When you charge something to a card and pay it back later in installments, you’re borrowing from a lender and paying interest on that money.
Other loans in the unsecured category are personal loans and student loans. If you default on those, there’s no risk of losing a collateral asset, but you will take a hit on your credit score and rack up high interest and late fees while you’re in default.
One advantage that you do have on an unsecured loan default is the option to settle it for less than the actual amount owed. This isn’t recommended, because you may end up with additional liabilities, but this option may be available in cases of financial distress.
Which Loan is the Right Fit for You?
Whether you should choose a secured vs. unsecured loan depends on your circumstances. You often can’t buy a new car or home without putting up the asset for collateral. On the other hand, student loans are almost always unsecured.
In cases where you do have a choice, such as personal loans, weigh the risk of losing an asset against the higher interest rates you’ll pay for an unsecured loan. If you feel that you can easily pay off the balance, go the secured route. When that’s in doubt, opt for unsecured.
Notice: Information provided in this article is for informational purposes only. Consult your financial advisor about your financial circumstances.
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