When you take out a secured loan, you provide some form of collateral (such as your home or car) to act as security for the lender, protecting them from loss if you fail to repay the loan. An unsecured loan does not use any collateral. Unsecured loans may be considered higher risk for the lender and can come with less favorable interest rates and terms.
What is a Secured Loan?
When you take out a secured loan, you agree to provide the lender with some form of collateral — something that has monetary value equivalent to or greater than the amount you're borrowing. The collateral acts as security for the lender, protecting them from loss if you fail to repay the loan.
Familiar types of secured loans include mortgages, vehicle loans and home equity lines of credit (HELOCs). For mortgages and HELOCs, your house serves as collateral. For auto loans, the vehicle you purchase is the collateral. Other types of secured credit include secured credit cards for which you deposit money equal to your credit limit in an account held by the lender, or title loans, which allow you to borrow against the value of your vehicle's title.
How Does a Secured Loan Work?
As long as you continue repaying the loan according to your agreement with the lender, you'll get to keep your collateral — and build your credit at the same time. When you pay off the loan, the collateral is yours.
Because a secured loan ensures the lender walks away with something of value even if you don't repay the loan, secured loans are generally considered lower risk. It's usually possible to borrow larger sums at lower rates and better terms when you choose a secured loan. The collateral may also make it easier to qualify for the loan, even if you don't have an excellent credit score. For example, it's possible to qualify for certain kinds of FHA mortgages with a credit score as low as 500.
What Happens if you Default?
If you default on a secured loan, the lender has the legal right — per your agreement with them — to take possession of the collateral. Defaulting on a mortgage typically results in the bank foreclosing on your house, while not paying your car loan means the lender can repossess your car.
Not repaying a debt can negatively affect your credit history and credit score, regardless of the type of debt. Defaulting on an unsecured loan can be especially bad, because the default can appear on your credit report and affect your score for a long time. For example, foreclosures and repossessions remain on credit reports for seven years, although their impact on credit scores can diminish over time.
What is an Unsecured Loan?
An unsecured loan isn't attached to any collateral. The only assurance the lender has that you will repay the debt is your creditworthiness and your word. Common types of unsecured loans include personal loans and student loans. Credit cards are another type unsecured credit, also known as revolving credit, where you essentially borrow and repay monthly.
How Do Unsecured Loans Work?
Just as with a secured loan, when you take out an unsecured loan you and the lender agree to certain terms for repayment, including an interest rate and how long you'll have to pay back the debt. However, because there's no collateral for lenders to claim if you default, unsecured loans are considered higher risk for lenders.
In order to qualify for an unsecured loan, you generally need to have a good credit standing and higher credit score. It can be more difficult to get approved for an unsecured loan, and it's likely the loan will come with a higher interest rate and less favorable terms.
What Happens If You Default?
Whenever you fail to repay a debt, it affects your credit. While unsecured loans have no collateral for the lender to claim if you don't pay, they're not without recourse if you default on the loan. Lenders can put your account into collections and take legal action against you to recoup some or all of the debt. Some lenders could also file lawsuits to recoup monies owed, and this could result in a civil judgment that would negatively impact your credit. Additionally late payments that are reported impact your credit negatively and future potential lenders will likely see that as a red flag before extending you credit.
Any kind of loan default negatively affects credit scores. Collections and civil judgments also show on credit reports for seven years from the date the account first went delinquent or the date of the ruling against you.
What Type of Loan is Right for You?
Whether a secured or unsecured loan is right for you depends on several factors, including how much you need to borrow and your credit score.
Secured loans can allow you to borrow larger amounts of money at lower rates, since the lender can be more confident they won't lose money even if you default. However, you do put your property at risk if you fail to pay. Unsecured loans don't put property at risk, but they can be more difficult to get and can have higher interest rates and typically, shorter terms.
Before you make any decision about how to use credit, it can be helpful to check your credit report and scores. Knowing your credit score and what's on your credit report can help you make more informed borrowing decisions.