There Are Two Different Types of Loans
Basically, a secured loan requires borrowers to offer collateral, while an unsecured loan does not. This difference affects your interest rate, borrowing limit, and repayment terms.
There are pros and cons to choosing a secured vs an unsecured loan, which is why we have highlighted the differences for you here.
Secured loans are protected by an asset. The item purchased, such as a home or a car, can be used as collateral. The lender will hold the deed or title until the loan is paid in full. Other items can be used to back a loan too. This includes stocks, bonds, or personal property.
Secured loans are the most common way to borrow large amounts of money. A lender is only going to loan a large sum with a promise that it will be repaid. Putting your home on the line is a way to make sure you will do all you can to repay the loan.
Secured loans are not just for new purchases. Secured loans can also be home equity loans or home equity lines of credit. These are based on the current value of your home minus the amount still owed. These loans use your home as collateral.
A secured loan means you are providing security that your loan will be repaid. The risk is if you can’t repay a secured loan, the lender can sell your collateral to pay off the loan.
Unsecured loans are the reverse of secured loans. They include things like credit cards, student loans, or personal (signature) loans. Lenders take more of a risk by making this loan, because there is no asset to recover in case of default. This is why the interest rates are higher. If you’re turned down for unsecured credit, you may still be able to obtain secured loans. But you must have something of value that can be used as collateral.
An unsecured lender believes that you can repay the loan because of your financial resources. You will be judged based on the five C’s of credit:
- Character – can include credit score, employment history, and references
- Capacity – income and current debt
- Capital – money in savings or investment accounts
- Collateral – personal assets offered as collateral, like a home or car
- Conditions – the terms of the loan
These are yardsticks used to assess a borrower’s ability to repay the debt, and can include the borrower’s situation as well as general economic factors.
Note that the five C’s of credit are different for personal loans vs. business loans.