Wondering what’s the difference between secured and unsecured loans? The main difference is that, unlike unsecured debts, secured loans and debt require collateral – an asset granted to the lender in the event of default. Whether you are thinking of taking out a new loan or are in the process of repaying it, it is important to know how secured vs. unsecured debt works. Here is an overview with examples and information on its advantages and disadvantages:
What is Secured Debt & Loans?
These debts and loans are “secured,” or backed, by assets such as money, real estate, or investments. This means that if you cannot repay the loan or debt, your lender will take the asset you have pledged as collateral. In exchange for this guarantee of getting something back, your lender may offer you better terms for the debt, such as a lower interest rate. The size of a secured loan may also be higher than what you could get with an unsecured loan:
- A mortgage secured by the property
- A car loan secured by the vehicle
- A credit card secured by a cash deposit
- HELOC, a home loan line backed by the home
Advantages of Secured Debt
While debt must be secured like a mortgage, it has advantages to get a secured loan over an unsecured loan if you have the option, either. If providing collateral gives you a lower interest rate, then that can save you a good chunk of money with your overall cost of borrowing. If you are trying to repair your credit, then responsible use of a cash-secured credit card is far better than paying for so-called credit repair companies.
Disadvantages of Secured Debt
The disadvantage with secured debt is that you run the risk of losing your collateral if you default or fail to repay the debt. That may not be too big a loss for collateral like $500 on a secured credit card. But for something like a HELOC, where a default could mean the loss of the home, much more is at stake. Depending on which state you are in, there is also no guarantee that the loss of collateral will pay off the debt. Another problem is that even if the asset is sold to reduce the debt, you could still be stuck if you have to repay the rest of the money owed.
What Are Unsecured Debt & Loans?
An unsecured loan is simply a debt that is not backed by collateral. Your credit score and source of income are crucial as lenders determine your credit score and how solid your repayment promise is. Unsecured loans mean higher risk for lenders and usually result in higher interest rates and stricter approval requirements for you. Examples of unsecured debt include:
- Credit cards that do not require a deposit
- Unsecured Personal Loans
- Unsecured credit lines
- Memberships, subscriptions, insurance, or utility bills paid in installments
- Student loans
- Bank overdrafts
- Payday loans
Why Can A Few Kinds of Debt Be Secured and Unsecured?
You may have noticed that some types of unsecured debt, such as a credit card, can also be secured. In fact, even a car loan that is normally secured against the vehicle can instead be taken out as an unsecured personal loan. The difference between secured and unsecured loans is whether or not you provide collateral, plus the different conditions on which this collateral causes interest, approval requirements, late penalties, etc.
Are Secured or Unsecured Debt and Loans Better?
Choosing between a secured loan and an unsecured loan, when you have a choice between the two, can be tricky. Interest rates and terms are more favourable for a secured loan. However, if you have trouble repaying the loan, an unsecured loan makes it easier to negotiate a repayment plan with your lender. Because if creditors can only take the collateral as payment, they have no reason to accept less. This is how it works with secured credit cards – it is usually not possible to owe more than the deposit in cash. Because this would simply be used to pay off the debt and the card would then be canceled if you got payment problems.
As with all debt, your goal should be a clear plan of how you will use it and how you will repay it. Do not enter into a credit agreement with a default plan. If you know that you cannot repay it, your best option is not to take out a loan so that you are accused of fraud. Of course, when you make these plans, you can consider unsecured versus secured options, as you weigh different payment terms and the risk of losing collateral against your financial situation. In the end, the better option is the one that better suits what you need, what your goals are, and what you can accomplish.