Lenders don’t simply hand out loans. In fact, before a lender can grant you a loan, they’ll first need to determine the risk you pose as a borrower. Specifically, the risk that you’ll default on your payments. And this is where your credit score, income, and assets come into play.
That being said, your loan in and of itself also influences the risk lenders will take. And depending on the risk assessment, you may or may not need to pledge collateral. Enter secured and unsecured loans.
In this article, we’ll be taking a look at secured vs unsecured loans. Particularly, what they are, how they differ, and which one is a better loan option.
What Is A Secured Loan?
A perfect example of a secured loan is a mortgage. To explain, a mortgage allows you to borrow money for a home purchase. In exchange, you agree to let your lender put a lien on the home. Or, in other words, you pledge the home as collateral.
The collateral essentially “secures” the loan. How? Because your lender can seize the collateral and sell it to recoup their losses. In short, a secured loan is a loan wherein you pledge an asset of value that the lender can use to settle the debt.
Other examples of secured loans include auto loans, secured personal loans, and secured credit cards. The main benefit of a secured loan: lower interest rates because of the lower lending risk. The biggest downside: you risk losing your asset if you’re unable to repay your loan.
What Is An Unsecured Loan?
In contrast, an unsecured loan is a loan wherein you don’t pledge collateral. Common examples of unsecured loans include traditional credit cards, unsecured personal loans, and student loans.
Yes, an unsecured loan will work the same as a secured loan will. However, because of the inherent risk, unsecured loans typically come with less favorable terms. This includes higher interest rates and lower loan amounts.
More importantly, lenders will rely more on your application when granting an unsecured loan. And this is where a higher credit score and lower debt-to-income (DTI) ratio comes in. Essentially, both your credit score and DTI ratio play a large role in determining your creditworthiness. Or, the likelihood you’ll repay a debt.
How Secured & Unsecured Loans Affect Your Credit Score
How a secured and unsecured loan affects your credit score is relatively the same. In the sense that on-time payments will improve your credit score. And failing to keep your account current will do the opposite.
With that said, a secured loan can have a worse effect on your credit score if you default. The reason: defaulting on a secured loan, such as a mortgage or an auto loan, may lead to a foreclosure or repossession. Both a foreclosure and repossession on your credit report can cause severe and long-lasting damage to your credit score.
What’s more, a foreclosure or repossession may still result in an account in collections. A collections account in your credit report is one of the worst things to happen to your credit score. And including your default, foreclosure or repossession, and the collections account, you can expect your credit score to fall quite a bit.
The Bottom Line
In summary, a secured loan is a loan wherein you’ll need to pledge collateral. In contrast, lenders don’t require collateral with an unsecured loan. Because of this, secured loans are usually the better option. For one, it typically comes with better loan terms, such as a lower interest rate.