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Unsecured vs. Secured Loans: What's the Difference?
Looking for a way to improve your financial stability? We often use loans to manage expenses and navigate major life events. Understanding the differences between unsecured vs. secured loans is a good step toward using loans to your best advantage.
The key is to balance your short-term needs with your long-term financial goals. Let’s review these two very different types of loans so you can make the most of your available resources.
What is an unsecured loan?
Unsecured loans do not require collateral. This means borrowers are not required to have any assets—like property or vehicles—to obtain the loan. Instead, approval depends on the borrower's creditworthiness, which is based on credit history and other financial factors. Here is what you can expect with an unsecured loan:
- No collateral. Your creditworthiness and financial stability are the main bases for loan approval
- Qualifications may be stricter. Since there is no collateral to mitigate financial risk for the lender, qualifications often include a higher credit score, a more favorable credit report and/or a better debt-to-income ratio
- Generally used for smaller amounts. Unsecured loans are commonly for smaller amounts than secured loans. They often are used for debt consolidation, special purchases, special occasions or unexpected expenses
What is a secured loan?
A secured loan requires collateral, with the value of the collateral increasing along with the loan amount. In the event of default by the borrower, the lender has the right to seize the collateral to recover the loan amount. Here is what you can expect with a secured loan:
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Asset needed to guarantee loan. Secured loans are backed by assets, providing a level of financial security for the lender in case of borrower default
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Examples of collateral. Collateral can include assets such as real estate (homes and/or land), cash, vehicles, art and jewelry
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Generally used for larger purchases. Secured loans are commonly used for significant purchases, such as buying a home (mortgage loan) or a vehicle
What are unsecured loans used for?
Unsecured loans offer versatility and can be used for many purposes.
Consolidate debt
Consumers can consolidate multiple high-interest debts into one loan with a single, more manageable payment. By combining debts like credit card balances or personal loans into one unsecured loan with a potentially lower interest rate, borrowers can simplify their finances and work toward debt repayment more effectively with a steady payment schedule.
Home renovations
For smaller-scale home improvement projects or renovations that don't require substantial financing or collateral, unsecured loans can be an excellent choice. Borrowers can use the funds to upgrade their homes, make repairs or enhance their living spaces without putting their property at risk.
Wedding expenses
Planning a wedding often involves many costs, from venue bookings to catering and attire. Unsecured loans can help cover these expenses, allowing couples to spread out the cost of their wedding.
Finance your vacation
Whether it's a dream vacation, a family trip, or a well-deserved break, unsecured loans can finance travel expenses. From flights and accommodations to activities and entertainment, borrowers can use the loan to fund memorable vacations without impacting their assets or savings.
Buy a new car
With an unsecured personal loan, you don’t need to use your car as collateral. You also don’t need to rely on the auto dealer’s financing. You can shop for a personal loan for your car target price. If you find a car for less, you can use the left-over money however you choose.
Medical expenses
Planned procedures and unforeseen medical bills can strain finances. Unsecured loans can provide relief by covering treatments, procedures, medications, hospital stays, and other medical costs. This helps individuals or families access necessary healthcare without immediate financial burdens.
Uses for secured loans
Secured loans are ideal for specific purposes where collateral is necessary:
Home Equity Loans and HELOCs
Secured loans play a vital role in real estate financing, including for homeowners looking to leverage their property's equity. Home equity loans and home equity lines of credit (HELOCs) allow borrowers to tap into the value of their homes for purposes such as home improvements, debt consolidation or major expenses.
Auto loans and other vehicles
When buying vehicles like cars, trucks, boats or RVs, secured loans are commonly used. The vehicle itself serves as collateral, providing lenders with security and borrowers with financing options tailored to their transportation needs.
Secured credit cards
Secured credit cards are a unique financial product where a cash deposit serves as collateral. These cards are often used by individuals looking to build or rebuild their credit history. By responsibly using a secured credit card and making timely payments, cardholders can improve their creditworthiness.
What to consider with unsecured and secured loans
When deciding between unsecured and secured loans, borrowers should consider several factors. Prioritizing responsible borrowing practices, maintaining financial stability, and understanding the implications of each loan type are essential steps toward effective financial management.
Making payments on time
Timely repayment is crucial for any type of loan. Missing payments can lead to late fees, penalty charges and a negative impact on credit scores. It's essential to budget effectively, understand the loan’s repayment terms and ensure that loan payments are made promptly each month to maintain financial stability and avoid default.
Credit score impacts
Both unsecured and secured loans can influence credit scores. Timely payments and responsible loan management can positively impact credit scores, demonstrating financial reliability to lenders. On the other hand, missed payments or defaults can negatively impact credit scores, affecting future borrowing capabilities and interest rates.
Financial institutions could take assets
With secured loans, borrowers must consider the financial risk of asset seizure by their financial institution or a collections agency in case of default. If repayments are not made as per the loan agreement, lenders have the legal right to take possession of the collateral, such as a property or vehicle. This default risk underscores the importance of budgeting and financial planning before accepting a loan.