Secured Loans Vs Unsecured Loans
All consumer loans fall broadly under two categories: secured and unsecured debt.
Secured debt is distinct from unsecured debt primarily because it requires some form of collateral to guarantee the loan.
Unsecured debt typically carries higher interest rates because they pose a greater level of risk to the lender.
In this article, we will further explore the difference between these two types of debt, examples of each, as well as an overview of when one type of financing may be more appropriate than the other.
What's The Difference?
- Secured Debt: This type of debt requires the borrowing party to pledge some type of collateral in order to guarantee the loan. Should the borrower default on their loan, the lender is legally entitled to seize, take ownership, and liquidate the pledged asset to recuperate any losses they may have incurred from the bad loan. Secured borrowings usually come with more affordable interest rates because of the lower level of risk for the lender.
- Unsecured Debt: Unlike the secured variety, unsecured loans do not require the borrower to provide some form of collateral to guarantee the loan; it is granted based on the borrower's creditworthiness. Unsecured debt almost always comes with higher interest rates than secured options because should the borrowing party default on their loan there is no asset that the lender can repossess to recuperate their losses.
Types Of Secured Loans
- Mortgage: When a person takes out a mortgage they are normally required to pay back the loan over a 15-30 year period. As the borrower pays off the loan, they develop equity, which can be thought of as their stake of ownership in the property. Should the borrower default on their mortgage, the bank will put a lien on the home, taking whatever equity the individual has built up in order to cover whatever balance is remaining on the mortgage.
- Car Loan: Cars loans operate on the same premise as a mortgage - a loan is granted for the value of the vehicle and is paid off over time. Should the borrower default on their loan, the lender will repossess the vehicle.
- Secured Personal Loans: Some individuals with poor credit may be required to secure personal loans or lines of credit with an asset of some sort. The pledged asset could be a property, vehicle, securities investments, or other valuables.
- HELOC: A home equity line of credit is a revolving line of credit that is secured by borrowing against the equity in a property. Should the borrower default on their HELOC, the lender has the right to take possession of whatever amount of equity was used to guarantee the loan.
Types Of Unsecured Loans
- Credit Cards: Credit Cards are the most common type of unsecured financing. The interest rates are high compared to secured debt and are granted based on the applicant's credit score.
- Personal Loans/Lines Of Credit: Personal lump-sum loans or revolving loans of credit are other common vehicles of unsecured debt. They typically carry interest rates lower than credit cards but higher than secured loans.
- Student Loans: Whether granted by the Federal Government or private lenders, student loans are another example of unsecured financing.
- P2P Loans: Peer-to-peer loans are a more recent example of unsecured borrowing. The loan is granted based on the applicant's credit score and should they default there is little action available for the lender.
Which Option Is Better?
Neither option is outright better, and the best outcome depends largely on one’s situation and what they want to achieve.
The main advantage of secured loans is that they carry the lowest interest rates.
They are for people who have a stable financial situation and are at little risk of defaulting on their loans.
Unsecured loans may carry higher interest rates, but the consequences for defaulting are less for the borrower than secured debt.
Below is a brief outline of the benefits of each debt type.