Secured vs Unsecured Loans: The Basics
Date: Mar 13, 2023
Table of Contents
II. Secured Loans
III. Unsecured Loans
IV. The difference between secured and unsecured loans
If you’re new to borrowing money, it can be difficult to wrap your head around financial topics like interest rates, collateral, or secured and unsecured loans. Before you borrow a penny, however, it’s crucial to familiarize yourself with the basics. After all, taking out the wrong type of loan can mean unwittingly borrowing more than you can afford—or worse, even risking assets you can’t stand to lose. Luckily, loans aren’t rocket science, so a little knowledge can go a long way. Specifically, loans fall into two broad categories: secured and unsecured.
Secured loans are backed by collateral, which are assets like a house or a car that someone pledges to a bank in exchange for a loan. If they fail to repay the loan, the bank can take the asset from the loan receiver to recoup their losses.
Unsecured loans, on the other hand, don’t require you to pledge collateral. If you default on an unsecured loan, the bank is out the money it lent you. However, there are still negative consequences, such as lowering your credit score and making it more difficult and expensive to borrow money in the future.
Below, we’ll take a closer look at secured and unsecured loans, and discuss their features, costs, similarities, differences, and more. By the end of this guide, you’ll have a good working understanding of both loan types—allowing you to borrow with caution and confidence.
II. Secured Loans
Secured loans, also called asset-based loans, or collateral loans, are lent (or “secured”) against property known as collateral. When you take out a secured loan, you pledge an asset to a lender like a bank or a credit union. Your lender (the bank or credit union) will then issue you a loan based on the value of the collateral asset.
Upon fully repaying the principal and interest owed your loan, your lender will release its claims against your personal property, and you’ll be free to pledge your asset as collateral for another loan. However, if you default on your secured loan—that is, you fail to satisfy the loan’s repayment or related obligations—your lender can take possession of the collateral you pledged.
Types of secured loans
Typically, lenders are more likely to require collateral for larger loans. For this reason, many secured loans stretch into the tens of thousands or even hundreds of thousands of dollars and are backed by high-value collateral assets like stocks, real estate, or automobiles. Here are some common types of secured loans.
In November 2022, the average price of a new vehicle in the United States hit $48,681—a $2,250 or 4.8% increase from the year prior. Most Americans can’t afford to buy a car in cash, which is why about 85% of new car purchases are financed.
In practice, vehicle loans are pretty straightforward. You simply apply for financing upon purchasing your vehicle and then pay off your loan in monthly installments. If you default on your auto loan obligations, your lender can repossess your car to recoup their losses.
However, because car loans are a form of secured financing, they typically command fairly affordable interest rates. As of January 2023, rates on auto loans range from 2.13% to 13.73%.
Perhaps the most common form of secured debt available to consumers, mortgages, account for over 70% of the roughly $16 trillion in debt owed by U.S. households.
This figure appears staggering, but the explanation is simple: a home is the largest purchase most Americans will ever make, and it’s one that many will happily borrow in order to afford. Of the 91 million owner-occupied homes across the country, about 63% of them are financed with mortgages.
This leaves the average homeowner with $222,592 in mortgage debt. While this is no trivial sum, mortgages are fairly inexpensive. In large part, because they are secured loans. The interest rate on a 30-year fixed-rate mortgage is 7.13% (March 10th 2023), while a typical 15-year fixed-rate mortgage charges 6.34% (March 10th 2023).
Home equity line of credit
Like mortgages, a home equity line of credit (HELOC) is secured against the value of your home. Unlike mortgages however, these HELOC are against a home that you already have ownership in. And because it is a line of credit, and not a “loan” you can choose to take money out or not as you need it. You also only have to pay interest on the money that you choose to take out.
Specifically, these loans allow you to tap the equity in your home—that is, the difference between the total value of your home and how much money left you owe on your home. Because most borrowers continue to carry primary mortgages against their homes, the average home equity loan is $83,872.
HELOCs also have competitive interest rates like mortgages—due to the nature of the loan being secured by your home. This is because home equity lenders have more confidence and safety in the fact that you are able to provide collateral for your loan. In return, lenders will provide you with a lower interest rate for extra security.
How secured loans work
Secured loans involve collateral that can be used by the lender if someone were to default on your loan. Fortunately, this is rare—only about 2.9% of auto loans and 1% of mortgages are in default nationwide.
If you’re among the vast majority of borrowers who make on-time payments, taking out a secured loan can be a good choice, since they come with lower interest rates and more favorable loan terms like longer repayment periods or higher approval amounts.
Additionally, secured loans can be easier to qualify for—especially if you don’t have good credit—and can even unlock access to tax benefits like the mortgage interest deduction.
Pros of secured loans
If you borrow responsibly, secured loans can be highly beneficial. You’ll be able to enjoy perks like:
Cons of secured loans
If someone is close to delinquency—or worse, default. They could be in the position where they could be forced to have their car, home, or any other valuable assets you pledged as collateral put into foreclosure. (selling the asset to pay back the loan originator and other associated cost, and the leftover money goes to the person that defaulted)
III. Unsecured Loans
Unsecured loans don’t involve collateral, meaning you don’t have to pledge assets to a lender in order to borrow money from them. However, that doesn’t mean you’ll be automatically approved. While lenders don’t require collateral for unsecured debt, they’ll still need to know that you’re creditworthy before lending to you.
Usually, this means that a lender issuing you an unsecured loan will rely heavily on your credit report, a document provided by credit bureaus that breaks down who you’ve borrowed from, how much you owe them, and how long you’ve been an active borrower for. Your lender will also take note of your credit score—a metric that distills your credit history into a number that offers an at-a-glance snapshot of your credit health.
Types of unsecured loans
As is the case with secured loans, unsecured loans come in several varieties. Here are a few common unsecured loans.
The average American has four credit cards and carries about $6,000 in credit card debt. But at 22.70%, credit cards carry the highest interest rates of any traditional financial product on the market today—making them one of the most expensive ways to borrow money. If you can, try to pay off your credit card in full every month so that you are not paying large fees and interest rates.
If you need access to money for unexpected expenses but don’t want to put up with high credit card borrowing costs, try an unsecured personal loan instead. These unsecured loans typically start at a much higher rate, in the double digits, due to there not being any collateral to secure the loan.
Unlike personal loans, student loans come with use restrictions. As the name suggests, you can only use this type of unsecured loan to pay for school-related expenses, like tuition, books, or housing. While federal student loans start at a low rate, private lenders often charge more and you are only allowed to use this type of loan for educational or education related purposes. Side note, student loans are the only kind of debt that you are unable to default on.
How unsecured loans work
Because lenders don’t demand collateral for unsecured loans, you won’t have to worry about losing your assets if you default. Though that may appear to create less risk for you, it doesn’t mean you’ll be let off scot-free.
For starters, unsecured loans come with higher interest rates. This is to compensate the lender for the increased risk they bear when they offer unsecured loans to borrowers—and it’s why credit card companies commonly charge ten times as much interest as mortgage lenders do!
Moreover, missing payments or defaulting on your unsecured loan can severely impact your creditworthiness. Your payment history accounts for 35% of your credit score, and even a single missed payment can lower your credit score by double or triple digits.
Pros of unsecured loans
That said, unsecured loans come with some unique benefits, like:
Cons of unsecured loans
There are also downsides to unsecured loans, such as:
IV. Difference Between Secured and Unsecured Loans
Before deciding between a secured or an unsecured loan, make sure that you understand their differences. Most notably, secured loans require collateral, while unsecured loans don’t—but this shouldn’t be the only factor you consider.
You should also determine how much—and at what cost—you want to borrow. If you want a higher loan limit and/or a lower interest rate, chances are that a secured loan may be your best bet. However, if you don’t mind paying up for short-term financing, an unsecured loan could be right for you.
Also account for your creditworthiness. If you have bad credit, you may want to opt for a secured loan, since those are typically easier to qualify for. If you have good credit, you do have the option for an unsecured loan, however, it will still likely be more expensive due to the added risk for the lender.
Finally, consider what you need the money for. If you’re looking to purchase a car or a home, then a secured loan is a natural fit. If you do not want to put up collateral for your loans, you may want an unsecured loan.
Secured and unsecured debt have different attributes, and the best loan for you will depend on your needs, goals, and financial situation. In any case, make sure to compare multiple lenders—including banks, credit unions, and online lenders—before borrowing.
If you’re ready to take the next step, we’d love to help! We’re Hitch, an online lender offering a home equity line of credit (HELOC) that you can use for any purpose. You can unlock up to 95% of your home equity in as little as five minutes—all with no impact to your credit score. Want to see how much the equity in your home is worth? Click here!