What’s the difference between a mortgage and a credit card? A lot, right? One is a large sum of money you use to finance a home, another is a card that lets you borrow money to make purchases.
What about the difference between a secured credit card and an unsecured credit card? A car loan and a student loan?
Figuring out the characteristics of each and deciding which one makes sense for you can be enough to bring on a massive headache. Fortunately, it doesn’t have to be as complicated as you might think. All you really need to know is how to answer one question: secured or unsecured?
The security of a loan refers to the amount of risk the lender takes when they loan you money. With a secured loan, the money lent to you is borrowed against an asset of yours, which acts as collateral. If you end up being unable to make your payments, your lender can take that asset from you as repayment (although if the asset doesn’t sell for the full balance of the loan, you’ll be responsible for the difference).
What Are Secured Loans Best For?
Secured loans tend to be a good option for borrowers who are taking out large loans and need a low interest rate, people who are trying to build credit, or those who’ve already tried to get an unsecured loan and were denied.
Because it’s fairly risky to secure a loan using property you own, you want to use these loans only when necessary or when the stakes are relatively low (like if you put down a small deposit to build credit on a secured credit card).
Certain types of loans will be secured due to the nature of the loan. Mortgages or car loans, two of the most common types of secured loans, are secured by the house or car you’re using the loan to purchase. When you can’t make mortgage payments, your house is at risk of foreclosure. Similarly, a car can be repossessed if the borrower defaults on their loan payments.
Secured loans like mortgages allow you to borrow a large sum of money at a lower interest rate than you would get with an unsecured loan. Since mortgages can take decades to pay off, you want the lowest rate possible, so you don’t end up paying a ton of money in interest.
You may also have heard of a secured loan called a second mortgage. With a second mortgage, you’re borrowing against your home’s equity. People will sometimes use these to pay for home repairs, or to cover the cost of college tuition. However, if at all possible, it’s better to take out an unsecured loan for these things, as you’re risking your home if you end up unable to make your payments.
Secured credit cards are another relatively safe form of secured debt. Secured credit cards are intended for people who either have bad credit that they want to fix, or people who have no credit and want to start building some. They require a down payment that acts as your credit limit, which secures the credit card company from the risk of losing money if you can’t make your monthly payment.
Secured credit-building loans, or loans that are backed by a savings account or Certificate of Deposit, work similarly in helping people build a good credit history. The lender holds your account as collateral, meaning you don’t have any access to it, and gives you the amount of money you pledge from the account. You make regular payments to pay off the loan, then you’re allowed access to the account again. They’re not good if you need a loan for any reason other than credit building, since you’re essentially borrowing money from yourself.
However, not all secured loans offer credit-building benefits or lower interest rates. In fact, a lot of the secured loans that are available tend to be bad deals.
Auto equity loans utilize the value of your vehicle to secure the loan. These might seem useful if you need fast cash in an emergency situation, but be extremely cautious, as these loans come with fairly high interest rates – your rate can be as high as 36%, depending on your credit – and you risk losing your car if you can’t make your payments.
Then there are auto title loans and pawnshop loans. With an auto title loan, you hand over the title to your vehicle in return for a small amount of money, usually from $100 – $5,500. Auto title loans tend to be short-term and don’t require a credit check. These loans have incredibly high interest rates, with APRs around 300%.
With a pawnshop loan, you take a valuable item you own – typically something like jewelry or a musical instrument – and leave it at the pawnshop in return for your loan. These loans can be a way to get cash if you don’t qualify for a traditional loan and can be better than borrowing money against something you actually need. However, pawnshop loans generally come with high interest rates as well, and unless your collateral is really valuable, it might be hard to find a pawnbroker who will loan you a significant amount of money.
How Can It Affect My Credit?
As with all loans (except pawnshop loans), on-time payments on secured loans will be reported to the major credit bureaus and positively affect your credit score. Late or missed payments will lower your score.
Your biggest worry with missed payments on a secured loan isn’t necessarily the impact it will have on your credit (though that is something to consider with all loans), but the possibility of losing the asset the loan is tied to. That’s why, if you start getting into financial trouble and have to prioritize your payments, you want to be sure to pay your secured debts first.
Try not to take on any unnecessary secured debts, especially ones tied to something as important as your house or your car.
Mortgages and car loans are more commonly-accepted forms of secured loans because they allow you to purchase things you need (shelter and transportation), but they don’t come without risks. Be cautious with your secured debts, and make sure you have a plan for how you’re going to repay them.
Depending on your loan and what state you’re in, you can be at risk of losing your asset as soon as you’re late on your payment.
With homes loans, the foreclosure process can’t begin until a homeowner is 120 days overdue on their payment, according to protections from the Consumer Financial Protection Bureau. With car loans, however, your creditor may be permitted to repossess the vehicle as soon as a payment is late, without any notice.
Foreclosures and repossessions will seriously ding your credit score, and they’ll remain on your credit report for seven years.
Unsecured loans rely on your creditworthiness to protect the lender from risk. Since there’s no collateral to secure the loan, lenders need to be careful about who they lend money to. Your credit score determines your creditworthiness, as lenders are more apt to loan money to people who have proved in the past to be good borrowers by always making on-time payments.
Your creditworthiness is also going to determine the kinds of rates you get with unsecured loans, so if your score isn’t so hot, you might want to consider looking at some credit-building secured loan options before trying for an unsecured one.
What Are Unsecured Loans Best For?
If you have the credit score to qualify for one, an unsecured loan can be a great tool to help manage your finances and build a strong credit history. Unsecured loans can also help you afford certain things that you wouldn’t normally be able to afford up front, like college tuition.
Unsecured loans can also be useful for debt consolidation, where you replace all your high interest debts with a loan that has a lower interest rate.
Student loans are a type of unsecured loan many of today’s college students are familiar with. These types of loans allow those who ordinarily wouldn’t be able to afford the high cost of college to attend and get a degree. They’re also considered to be a good form of debt, because you’re borrowing money to invest in your future.
There are also personal loans, which can have a diverse array of uses. Some common uses include debt consolidation, paying off medical bills, home repair or renovation, or even paying for a wedding.
Credit cards are also considered a type of unsecured loan. As previously mentioned, you can get a secured credit card, but the purpose of those are to build up your credit enough to qualify for an unsecured card. Once you have an unsecured card, you’ll have a higher credit limit and won’t have to deal with security deposits.
How Can It Affect My Credit?
Failing to make on-time payments with an unsecured debt can severely impact your ability to get unsecured loans in the future, since they rely so heavily on having a good credit history.
When you default on an unsecured debt, the lender doesn’t have the same recourse as they would with a secured debt. However, you’ll still face some pretty stiff consequences, from having the debt sent to collections, to being sued, to wage garnishment. All of these can have a huge impact on your credit score and can remain on your credit report for years.
The one small silver lining to these situations is that a creditor cannot seize any property you own without first going to court. Because entering into a lawsuit can be a hassle, creditors of unsecured debts will typically explore alternate routes first, like sending the debt to collections.
Can You Secure an Unsecured Loan?
It’s possible to take any unsecured debts you owe and transfer them over to a secured loan. But should you do it?
While lower interest rates might make this move look attractive and cost-effective, it can actually be quite financially dangerous to take a currently existing debt and tie it to a vital asset.
The main reason you would want to turn an unsecured debt into a secured one is if you’re looking to consolidate a large amount of debt with a home equity loan. With a home equity loan, or second mortgage, you might be able to borrow significantly more money and get a lower interest rate than you would with an unsecured debt consolidation loan.
If you’re at the point where your debt situation is dire enough to consider this option, make sure you take a look at your finances as a whole and really plan for how you’d pay off a secured loan of this nature. If you find your debt to be insurmountable, you may want to start looking at options for debt relief, such as bankruptcy.
It might also help to speak to a debt counselor. If your debts are the result of poor money management, looping your valuable assets into that are likely to make the situation worse. You’re better off addressing your spending and saving habits as well as looking into how to stabilize your situation and avoid future problems. A debt counselor can help you with these things.
So Which Type of Loan Is the Best for Me?
As you can see, there are only a few specific situations where a secured loan really makes sense – home or auto purchases, debt consolidation (depending on the situation) and credit building. With other secured loan options, you’re taking a significant and often unnecessary risk.
This is why building credit early on is so important. If you have good credit, you’ll be more likely to be approved for unsecured loans and won’t have to worry about borrowing against assets you can’t afford to lose.
If you’re not trying to build credit or borrow a large sum, an unsecured loan is going to best meet your needs; whether that be paying for college, debt consolidation or paying for something you can’t afford up front, like a pricey home repair.
In what situations have you sought a secured or unsecured loan? Let us know in the comments below!
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