Loans are a form of debt and people take out loans for a variety of reasons. For instance, you may take out a loan to purchase a home or for a car. You may also take out student loans for your education. It's not uncommon for people dealing with health issues to take out medical loans.
However, not all loan debt is created equal and without care, it can get really expensive. Commonly, loans are broken out into secured and unsecured loans.
Ever found yourself wondering what the key differences are between secured vs unsecured loans? Well, understanding how each loan type works can position you to make smart financial decisions if you need to leverage debt.
Let's get into it.
What is a secured loan?
A secured loan or secured debt is a type of debt that is backed by an asset that acts as collateral. Basically, the lender, also known as the lienholder, can seize the associated collateral and use it to pay your debt if you fall behind on your payments.
Secured loans are typically less risky for lenders. This is because they have assets associated with the debt. As a result, interest rates for secured loans are typically lower than unsecured debt.
A standard example of a secured debt is a mortgage.
Mortgages are tied to an asset, for instance, a residential or commercial piece of real estate. Typically, you take out a mortgage on a property with predetermined monthly payments. If you default on your payments, your lender will send you past due notices. If this goes on for an extended time period, they might begin foreclosure proceedings to repossess the asset.
They will then attempt to sell the property to cover the debt you owe. However, if the sale of the asset does not cover the debt in its entirety, you may be liable for the difference.
Another example of secured loans are auto loans.
With secured loans, you don't own the asset outright until the debt is paid off in full.
What about secured credit cards?
Now that we've talked about secured loans you might also be wondering about secured credit cards. A secured credit card is a type of card requires a security deposit. This deposit can be as low as $200 and is usually equal to your desired credit limit.
The credit card issuer holds onto your deposit in case you default on your payments. Secured credit cards are typically used if you need to improve your credit score and history.
What is an unsecured loan?
An unsecured loan or unsecured debt is a type of debt that is not tied to any asset as collateral. As a result, these loan types are risker for lenders and typically come with higher interest rates. This is why a mortgage interest rate can be 5% and a credit card's interest rate can be 20%.
Although there isn't an asset that can get repossessed, you can still be impacted if you default on your payments. Examples of unsecured debt are personal loans, credit card debt and student loans. Medical debt and child support also fall under the unsecured debt category.
Credit reporting for secured and unsecured loans
Failing to pay any debt can result in late fees, penalties and negative remarks on your credit.
Falling behind on secured loans can result in assets being repossessed and additional liabilities. Falling behind with unsecured loans can result in your account being sent to collections. With debt like back owed child support, it can result in jail time by court order.
All of these actions can hurt your credit score, making it hard for you to secure good loan terms in the future. It may also impact your ability to even get a loan or any form of credit at all. Yup, this includes actions taken by child support enforcement agencies about unpaid child support.
Using secured vs unsecured loans
When it comes to using a secured or unsecured loans, you want to make sure you are being intentional. You can do this by shopping around for the best loan rates. You also want to make sure you are not borrowing more than you really need or can afford.
It's not a bad idea to see how much you can save on your own before you consider leveraging debt. At the end of the day, debt comes at a cost and that cost is in the form of interest. So it's important to be cautious when it comes to leveraging debt.