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This chart using data from Experian highlights that for the average American, 71.7% of consumer debt relates to mortgages. This is followed by 10.1% for both student loans and auto costs.
The choice of secured vs unsecured loan will depend on your circumstances. If you don’t have any security items, so you don’t own a home or vehicle that can be used to secure your loan, an unsecured loan may be your only option.
However, if you’re not in a particular rush for the funds and prefer a more beneficial rate, you should look for secured loans. Just be aware that you will need to be very careful to make all your payments on time, as if you default, your security item could be at risk.
Are Unsecured Loans Riskier Than Secured Loans?
Unsecured loans are considered riskier than a secured loan for lenders. Since there is no security for the loan, should you default, it is more difficult for the lender to recoup the debt. For this reason, unsecured loans tend to have higher interest rates compared to secured loans.
However, unsecured loans tend to be quicker to obtain. There is no need for the lender to appraise a home or other security to finalize the loan. So, the lender simply looks at your finances to determine if you qualify.
Secured Loans: How Does It Work?
These are loans that are secured by collateral or various assets. This means that the lender can impose a lien on the collateral in the event of missed payments or defaults. Usually, the item you purchase is used as collateral – your home or car or anything else.
Lenders can foreclose, repossess or take other actions to seize assets if a borrower defaults in repaying a secured loan. Secured loans are less risky than unsecured loans and have lower interest rates.
For example, in the case of secured vs unsecured personal loans, a borrower with a high credit score may qualify for an unsecured loan with a low-interest rate without having to pledge any collateral. An applicant applying for an unsecured loan may not be eligible and must rely on a secured option due to greater risk. One type of loan isn't necessarily better than the other, but it's important to understand your options before signing on the dotted line.
Secured loans allow borrowers to access cash lump sums to pay for everything, from home improvements to buying a home or a car. These loans can be obtained from traditional banks, credit unions, or online lenders.
Even though secured loans are less risky for lenders, the application process generally requires a hard credit check–though some lenders offer the ability to prequalify with just a soft credit inquiry. And, while secured loan balances accrue interest like other loans, borrowers may access lower annual percentage rates (APRs) than are available with unsecured options.
In this chart compiled with LendingTree customer data, you can see that those with a 720+ credit score pay an average of 7.63%. At the other end of the scale, for those with a poor credit rating of less than 560, the rate shoots up to an eye-watering 113%.
Secured Loans – Pros & Cons
These loans offer borrowers the best possible conditions on the market – lower interest rate and higher borrowing limits. In addition, the term of the loan can be much longer than what unsecured loans offer.
However, A serious drawback is the fact that should you fail to repay your loan, the lender will take the collateral. This is awful when we are talking about your home. So be careful and make sure that you make payments on time.
- Eligibility
Secured personal loans are available for those with poor credit scores or a poor credit history. A personal loan may not be available to you if this is the case.
- Many Types of Lenders
Secured personal loans are offered by banks, credit unions, as well as online lenders. You can compare rates, fees and repayment terms with multiple lenders.
- Potentially Lower Interest Iates
If you have good credit, personal loans have lower interest rates than other forms of borrowing like credit cards.
- Your collateral could be lost
Secured loans are when you pledge an asset to get a loan. You could lose your asset if your loan is not paid on time. Your credit score could also be affected if your payment is late more than 30 days.
- Maximum loan amounts could be limited
A secured loan of $5,000 is possible if you have $5,000 in cash but need $10,000. You may not be eligible to borrow the amount you need if you don't own enough assets to pay off your loan.
- There are fewer options than unsecured loans
Secured personal loans are available from banks, credit unions and online lenders. However, you will have fewer options than unsecured personal loans. You may want to consider other options if you are unable to qualify for the few options available.
Examples of Secured Loans
- Mortgage: It's a loan that banks or building companies give an individual to buy a property. The collateral here is the real estate. There are many types of loans and the customer can choose between fixed-rate, ARMs mortgage or even a combination of them.
- Auto and car loans are a type of funding given to people when purchasing a car (both new or used). The collateral, in this case, is the car.
- Borrowers who want to purchase a recreational vehicle usually take out a recreational vehicle loan.
- Others would like to have a boat and can apply for a boat or RV loan.
- Home Equity Line of Credit (HELOC) is often referred to as a second mortgage. The borrower's property is once again, just like in the case of a mortgage, collateral.
Unsecured Loans: How Does It Work?
These are loans that have no “security,” which means that there is no collateral. Some of these loans include credit cards, personal loans, student loans, etc. If the borrower defaults on their debt, the lender doesn't have anything to compensate for the losses.
This uncertainty is what makes the conditions on these loans less attractive – they carry more risk. Often lenders may refuse borrowers an unsecured loan. But don't give up if you really need money to take out a secured one. Even though these loans are often called “signature” loans (because your signature is the only collateral they have), the bank will evaluate two main factors before they approve the loan.
1. Credit – Definitely the lender will assess your credit history. They will check if you have any previous or other debts also if you have missed payments and so on. Then they can have an idea of your credit score, which can also determine the interest rate on your loan.
2. Income – Are you sure you can really afford this loan? The lender will make sure! They would ask you a proof of income and will calculate the debt-to-income ratio which is crucial when deciding.
Unsecured Loans Pros & Cons
Personal loans and other unsecured loans offer many advantages over other types of loans. However, you should carefully consider the risks.
Here are the main benefits and drawbacks of unsecured loans:
- No Risk of Losing Collateral
There are personal loans that can be secured, and those that don't. Personal loans that are secured have collateral backing them. This means your lender has the ability to take your loan if you don't pay it off.
An unsecured personal loan has the advantage that your personal property is not at risk in case of default. If you are laid off or unable to make on-time payments, you don't have any risk of losing your home or other assets.
- Simple Process
The process of getting a personal loan is not as difficult as it used to be. Financial institutions want to make sure that they only lend to businesses that are able to pay their bills on time and repay their debts fully. There are many lenders available, including banks and credit unions. You can apply for a loan from a peer-to-peer lending site from the comfort of your own home. It's easy to get approved in as little as 24 hours.
Your credit history and credit score will determine whether you are eligible for a loan. You will also need to prove that you have a steady and reliable source of income.
- No Collateral Needed
Many businesses don't have collateral. For example, a startup may not have valuable business assets that can be used as collateral. This would render the startup unqualified for secured business financing. Unsecured business loans don't require collateral. When a company is qualified, it takes into account other factors, like market opportunities and business plans.
Startups or businesses without collateral often qualify for unsecured business loans. If your business falls into one of these categories, it’s a good idea to explore unsecured options first. Keep in mind that the lender might request a personal guarantee to approve the loan. This legal agreement means the lender can pursue your personal assets if you’re unable to repay the loan.
- Higher Rates
– Lenders tend to charge higher interest rates because unsecured personal loans can be more risky than loans secured by real property. The amount you borrow and your credit score will determine how much higher the interest rates. Interest rates for unsecured personal loans were 3% to 36% as of May 2021. Lenders may conceal a portion of higher interest rates by charging upfront fees, such as application fees and loan origination fees.
Your monthly payments may be higher if you have a higher interest rate than a secured loan. The longer you repay, the higher your interest rate. It is important to ensure that your monthly payments are within your means before you sign off on any loan. You may be subject to severe late payment penalties if you fail to pay your regular monthly payments.
- Smaller loan amount
Financial institutions will go to great lengths not to make sure the loan amount is repaid. They may even sanction lower amounts than secured loans if there is no collateral.
Personal loan interest rates are often high, and the borrower runs the risk of getting into debt. You might find it difficult to repay the loan at high interest rates within a short time frame.
- Strict eligibility criteria -
There are strict guidelines for personal loans. Many banks require applicants to have a certain income before considering an application.
Also, the applicant's credit score will be scrutinized. A low/average credit score can lead to an applicant's application being rejected.
Examples of Unsecured Loans:
- Credit Cards are the most common unsecured loans. They grant their holders a line of credit, which they can use anytime they need.
- Personal Lines of Credit allows you ongoing funding, just like credit cards, when you need it.
- Personal (Signature) Loans are unsecured loans usually used for general purposes.
- Student Loans cover tuition fees and other expenses accumulated during the process of acquiring an academic degree.
- Home Improvement Loans are types of personal loans and people use them to cover expenses related to improving their home.
Carrying a credit card balance can significantly impact your financial health. If you carry a balance, you are not only incurring interest, but it can affect your credit utilization ratio. Unfortunately, bringing down a credit card balance can be difficult.
We can see the average credit card balance per family on the chart using FED Survey of Consumer Finance data
Is an Unsecured Loan Safe?
As with any type of debt, if you have an unsecured loan with a reputable lender, it is certainly safe. There are many well established banks and financial institutions that offer unsecured loans.
However, while there is no security that can be seized, your credit is at risk if you make late payments or miss any loan payments at all. Each time you make a payment, it is recorded with the credit bureaus, so it is crucial to maintain a record of on time payments or your unsecured loan may compromise your ability to obtain credit in the future.
Another area where your unsecured loan may be detrimental is if you want to get a mortgage or other lending product. Your potential lender will consider the total amount of your debt to determine if you can afford a new loan account. So, if you are considering buying a home, you may need to pay down your unsecured loan to qualify.
How Do Secured and Unsecured Loans Affect Your Credit?
Both secured and unsecured loans have an impact on your credit. While there is an initial dip in your credit score due to the hard pull of your credit during the application process, if you properly manage your loan account, it can actually help your credit.
Every time you make a monthly loan payment, it will be logged with the credit bureaus. Likewise, if you miss a payment or it is late, it will also be noted on your file. So, if you consistently make your payments on time, it will benefit your credit.
One way your credit could be affected is through your credit utilization ratio. When you open a loan account, your ratio will go up. For example, if you take out a $10,000 loan, your total available credit will be $10,000, and your balance will also be $10,000. If you don’t have any other credit accounts, your credit utilization ratio would be 100%. As you pay down the loan, your balance and ratio will decrease. However, you may find it harder to qualify for additional credit while your ratio stays high.
Open vs Closed Ended Loan – What's The Difference?
You can choose between an open-end or closed-end loan. Closed-end loans are often installment loans. They have a fixed amount and are repaid over a predetermined time. On the other side, a lender or financial institution may issue an open-end loan, which is a revolving credit line.
1. Open-Ended Loans
As their name suggests these loans are “open” and there is no specific date for repayment, which means that you can borrow money over and over again.
Do you have a credit card?
If the answer is yes, then you are a “proud” owner of an open-ended loan. Nevertheless, these types of loans have a limit – the maximum amount of money you can borrow at one time.
For example, you have a credit card with a $10,000 limit. This is the amount you can borrow as long as you have it. If you buy something, this amount will go down – let's say something that costs $500. Then you will be able to use only $9,500. As long as you pay off the balance, this credit limit will be restored.
Open-ended Loans give you the freedom to borrow again if you really need it. On the downside, keep in mind that there is no payoff date. This means that your interest rate will change and sometimes might increase. Automatically, this will result in higher monthly payments.
2. Closed-Ended Loans
These are loans that are fixed – the borrower cannot change the term of the loan nor the amount and number of the monthly payments. If you have a closed-ended loan, you cannot borrow the amount again. For instance, mortgages, personal loans, student loans are typical examples.
A word of caution:
As a serious drawback, we can consider the fact that you don't have any available credit to use in times of need. Instead, you have to take out a new loan or use refinancing. In addition, if you want to change the conditions of your current contract, the lender will impose fees and penalties which you have to pay. However, these types of loans are very suitable for specific purposes – buying a car, a house, etc.
3. Conventional Loans
A conventional loan is a type of mortgage, which is not insured by a government body such as the Federal Housing Administration (FHA), Rural Housing Service (RHS), or the Veterans Administration (VA). They can be usually two types – conforming and non-conforming. The former are mortgages that follow the requirements set by the Fannie Mae and Freddie Mac. The latter does not conform to the limits set by the two government agencies.
Most experts think that conventional loans offer great rates and are a very safe option. In addition, lenders usually spend less time approving a conventional loan than other types, for example, FHA backed loans. They require less information and the process is faster.
These loans require higher down payments – up to 20% of the loan value. In order to obtain these very good interest rates, you'll need a fantastic credit score.
Bottom Line
The diversity of loans you can take advantage of is incredible. Before taking out one, make sure you know what you would like to achieve with it. Also, you have to know virtually everything part of your agreement.
Be particularly careful with several major things:
The first one is your monthly payments and what happens if you miss or delay one. Secondly, pay attention to the interest rate (fixed or variable) and the term of the loan. Last but not least, familiarize yourself with all the fees, charges, penalties. The more you know, the wiser choice you will make.
FAQs
What are the main advantages to a secured vs unsecured loan?
The main advantage of a secured loan compared to an unsecured loan is that you can typically expect a lower interest rate. Since there is less risk for the lender, this is usually reflected in the rates. Additionally, as the lender has security that can be liquidated to recoup any losses in the event of a loss, secured loans can be easier to gain approval if you have less than perfect credit.
The downside to this is that the lender will not only look at your income, credit history, and finances but also need to evaluate the security or asset. So, if you’re using your home as security, the lender will need an appraisal, which can delay the loan process. This means that if you’re looking to get your funds quickly, you may find obtaining a secured loan a frustratingly slow process.
What qualifies as unsecured debt?
As the name suggests, unsecured debt is any type of debt that is not tied to a form of security. This means that conventional credit cards, personal loans, medical bills and even student loans are classified as unsecured debt.
While many people assume that an auto loan is unsecured, this is usually not the case. Many auto loans use the vehicle purchased as security for the loan. This means that if you miss a car payment, the lender has the right to recoup its losses by seizing the vehicle. Therefore, this means that these loans are certainly not unsecured debt.
Why would a secured loan have a lower interest rate than an unsecured loan?
Lenders calculate interest rates according to risk. This is why if you have good credit, you can obtain a better rate compared to someone with poor credit.
In terms of secured loans vs unsecured loans, secured loans provide the lender with less risk. In the event of a default, the lender can seize the security item to recoup its losses. For this reason, secured loans tend to have lower rates compared to unsecured loans.
