Secured vs. Unsecured Loan: How Do I Know Which Is My Best Option?
When looking for a loan, you will have several options, including personal, debt consolidation, refinancing, and more. The two most common personal loan types are secured and unsecured. While both loans serve the purpose of getting the extra money you need, they have some significant differences that you will need to consider. Here are some of the essential factors of each loan type to help you decide which is the best option for your needs.
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What is a Secured Loan?
Secure loans are loans that require something to be used as collateral for securing the repayment of the loan.
Meaning the lending will take possession of your collateral if you fail to make your payments. There are many options for securing these loans, depending on the financial institutions with whom you are working. Some agencies require collateral like automobiles, houses, boats, and other property of value.
Other institutions will accept security in the form of a savings account and in some cases any items of value like jewelry or stocks.
General rules for secured loans allow for borrowing up to the value of your collateral.
This amount will be dependent on your personal credit score, the institution you are borrowing from, and the specific property being used. With secured loans, the collateral that you use will be a guarantee of repayment.
Should you default and not pay back the loan, the financial institution will be able to take possession of the collateral property used to secure the loan. In some cases, though, you may be required to pay an amount above your collateral.
This would be the case if the financial institution sold your property for repayment, and the price received was not enough to pay off your loan.
What is an Unsecured Loan?
Unsecured loans are personal loans that are obtained without collateral. Because there is no collateral, your credit score will play an essential role in approval odds, the amount you are able to borrow, the terms of the loan, and interest rates.
With an unsecured loan, the lending company will not be able to take your property if you default on payments. However, depending on the regulations in the state you live in, they do have other recourses to protect them against this loss.
If you default on your unsecured loan, the lending company will report this as a negative report to the credit bureau, which will lower your overall credit score and make approval for other types of loans in the future more difficult.
Other recourses lending companies have will vary from state to state, but can include court proceedings, garnishments, judgments, and more.
Differences Between the Two
Now that you know the basics of each of these loan types, you need to understand the differences between the two.
While the most obvious is, of course, the required collateral for secured loans, there are several other factors to consider.
Other than the collateral, one of the most significant differences between secured loans and their unsecured counterparts is the interest that is charged on each.
Interest charged for loans and any credit varies from lender to lender and person to person.
Your credit score and payment history will play a significant role in deciding your interest rates.
That being said, in many cases, unsecured loans will often have a higher interest rate than secured loans.
This increase is because of the risk the lending company is taking in both instances — secured loans have a higher probability for repayment, allowing them to charge lower interest rates.
Another difference between secured and unsecured loans is the level of credit needed to obtain the loan.
Unsecured loans will generally require a higher credit score for approval than that of a secured loan.
Lenders look at credit scores to determine the likelihood that the loan will be repaid on time and therefore, the higher the score, the more likely they are to make the loan.
While secured loans do require a certain level of credit score, it is often easier to get secured loans with lower scores due to the guarantee of the collateral.
One final difference to note between secured and unsecured loans is the amount of the loan.
Secured loans are going to be given based on a combination of the borrower’s credit score and the value of their collateral while unsecured loans are based on the creditworthiness of the borrower and their income. In general, unsecured loans will be lower than those of secured loans, again due to the risk perceived by the lender.
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What Difference Does the Interest Make?
Now you may be wondering what difference your interest rate makes and why it is important.
The interest rate of your loan will ultimately determine how much you pay back for the money you borrowed. The higher the interest rate, the more you will be paying in the end.
Let’s use our two loan types to compare. Starting with the secured loan, say you received a collateral loan in the amount of $1800 and that you have an interest rate of 12%, and monthly payments of $150.00.
At this rate of interest, you will pay a total of approximately $127 in interest and pay of the loan in roughly 13 payments.
If you use the same reference amount and consider an unsecured loan with a 26% interest rate, the changes are significant.
A loan for $1800 with an interest rate of 26% and $150.00 monthly payments leaves you paying about $307 in interest and making approximately 15 payments.
While the difference may not seem that extreme, these numbers will change depending on the interest rate, the term of the loan (number of months given for repayment), the amount of the initial loan, monthly payment amounts, and many factors after you start the repayment process.
Late payments also play a crucial role in the final price you pay for the initial loan. You might want to take a look at a budget calculator or an interest calculator to see how much you can afford or what you will be paying long term.
Which One Is Right For Me?
Deciding which loan is right for you will take some consideration and homework on your part.
Having a general understanding of your credit score and payment history will go a long way towards helping you make this decision.
Other considerations to take into account will be your gross income, length of time on your current job, total debts owed at the time of your loan application, the reason for requesting a loan, and the amount of the loan you are applying for.
Each of these factors will play into your qualifications for either loan type. If your credit score is low, getting an unsecured loan may pose some difficulties; however, depending on your other factors, it may still be possible. Secure loans are generally easier to obtain with lower credit scores because of the reimbursement guaranteed by your collateral.
Credit score ranges as well as gross pay will help determine the rate you are qualified for.
For either loan, lenders usually are going to want to see that you have a consistent work history and that you are not likely to be unemployed before the loan repayment is completed.
This factor, along with other debt amounts, is one of the top questions on any loan application. Income factors in because it shows your ability to pay, total debt is a concern as to how much of your income will be able to be applied to this new loan payment.
If you have declared bankruptcy or filed for bankruptcy then you may have a harder time securing a loan.
In the end, deciding which loan type will be better for you will be a personal decision as much as a financial one.
You will need to assess your current bills and personal circumstances to judge which loan is better for you.
If you have a below-average credit score and have collateral to use, a secured loan maybe your best option.
Keep in mind though, that if you should default on the loan, your collateral will be lost.
If on the other hand, you have a reasonably good credit score, an unsecured loan with an average interest rate maybe your best option.
Many borrowers have options for free credit cards with free interest. Or you may qualify for student loan forgiveness. Those may be an option for you.
One final note to remember when applying for either loan is to make sure that it is within your budget. Assess your current bills and income.
Make sure that you figure in the new loan payment and then decide whether the loan is feasible for your current situation and needs.
Finally, make sure you make all of the payments on either loan type. These timely payments will work to increase your overall credit score and offer you lower interest rates if future loans are needed.