What is the difference between a secured and an unsecured loan?

Taking out a loan is likely a must if you're planning a big purchase that you don't have the cash to cover. Most people take out loans when purchasing homes and other properties. Some also take out loans to buy cars, RVs, and other types of vehicles, or to pay for tuition when attending college. A personal loan can help if you want to buy something and spread out the cost over time. Understanding the difference between secure loans and unsecured loans can help you determine which applies to the loan you plan to take out.

What is a loan? 

Before breaking down the differences between secured and unsecured loans, it's helpful to understand what a loan is and when you can use one. Loans are material goods given by one party to another in exchange for the future repayment of the value. Loans are typically subject to accruing interest, which is the charge applied to the loan amount that the borrower must pay for the privilege of borrowing money from the lender.

If the borrower fails to meet the terms of the loan, the lender can take certain actions against them. The type of loan determines what action can be taken. For example, if you take out a loan to purchase a vehicle, the terms of the loan might indicate that the lender can take the car back if you fail to make your monthly payments on time.

Secured loans

One question that often comes up among people who are considering taking out loans is, what is a secure loan? Secured loans are used to purchase physical items, such as houses and cars. The physical item purchased serves as collateral on the loan that the lender can repossess or take back if the borrower doesn't adhere to the agreed-upon terms. Other assets that might serve as collateral for a secured loan include:

• An insurance policy, such as a life insurance policy
• Bank accounts, including savings and checking accounts, money market accounts, and CDs.
• Investments, including stocks, bonds, or mutual funds
• High-end valuables or collectibles, such as antiques or precious metals
• Machinery or equipment

A home equity line of credit (HELOC) is a secured loan because it requires the borrower to have equity in the house, which then serves as the collateral. Most credit cards qualify as unsecured loans, although some secured credit cards are only available to individuals who put something down as collateral. A business loan may be considered a secured loan if the funds are used to buy equipment or invest in business-related projects. On this type of loan, the collateral might be the building, equipment, or inventory used to operate the business.

When taking out a secured loan, you typically agree to allow the lender to put a lien on the asset you're purchasing with the funds provided. When you pay off the loan in full, the lien comes off the asset and you no longer have a secured loan. However, if you don't make the payments on time or fail to pay the full amount each month, the lender can seize the asset and make a report to the major credit bureaus, damaging your credit score. A repossessed asset remains on your credit report for seven years.

Unsecured loans

If a secured loan can involve collateral and liens, then what is an unsecured loan? By contrast, an unsecured loan is a loan that doesn't require any collateral. However, interest and fees still apply to unsecured loans, and the interest rate may be higher than on a secured loan because the lender is taking on increased risk.

If a borrower fails to repay an unsecured loan, the lender doesn't have as much recourse because they can't repossess the physical asset purchased with the funds. However, lenders can make a report with the credit bureaus, which will impact the borrower's credit, as well as move the account into collections.

Examples of unsecured loans include:

• Student loans
• Most credit cards
• Many personal loans

People take out personal loans for many purposes, including home renovations, vacations, major events, and medical treatments or procedures. Some people choose to use unsecured personal loans for debt consolidation, as the interest rate on this type of loan is often lower than what is available on a credit card.

Interest rates on secured vs. unsecured loans

The interest rate on a loan depends on several factors, including the borrower's credit history and the loan type. In general, interest rates on secured loans are lower than those on unsecured loans because a lower level of risk applies to the lender. However, your individual financial situation and credit score will factor into what rate you can qualify for on either type of loan.

How to apply for a loan

If you want to make a purchase and need to borrow funds to do so, a loan may be your best option. Many lenders offer both secured and unsecured loans to qualified borrowers. The first step in the process is determining whether the loan you want to apply for will be secured or unsecured. If you're using the money to purchase a physical asset that the lender could take back, the loan will likely be secured.

When you figure out which loan type you need, you can submit an application through a trusted lender.

If your credit score is low, consider trying to raise it before applying for a loan since it will factor into whether you qualify for a loan at all. Paying down or consolidating debt can help lower your debt-to-income ratio and help increase your credit score. Other tips to improve your score include requesting an increase to your credit limit, which will lower the utilization ratio, and negotiating a lower interest rate on existing credit accounts. After raising your score, you can apply for the loan you need and potentially qualify for a better interest rate.

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Check out our blog to learn more about personal loans and when it might make sense to refinance one of your loans. Here are a few posts to get started:

• What is an unsecured personal loan? 
• 3 things you want to know about personal loans 
• Which types of loans make sense to refinance?