Whenever you have to take out a loan or any form of debt to your name, this debt is going to be either secured or unsecured. Any sort of debt can fall under these two different denominations. It’s important to understand the difference between them because your loan terms are heavily dependent on it.
What Is the Difference?
Let’s start with secured debt. This refers to a loan that has collateral backing it up. Collateral is an asset or object of some value that is used to back up a line of credit or loan. Therefore, a secured loan has some sort of asset that you own backing up the debt you owe. So, if you stop paying back the loan, then the lender has the authority to make up their losses by acquiring this collateral as compensation.
That is a secured loan at its most basic. If you want an example, then you’re going to get two of those! A perfect example is a vehicle paid for by an auto loan. In most cases, this vehicle is the collateral on that auto loan, so if you stop making payments, then the lender will get someone to repossess the car! Boom, they have a new car and can sell it to someone and make up their losses. Another example is a mortgage which is backed up by the very house you’re living in. When you default on a mortgage for too long, then the lender has authority to eventually take the house as collateral (known as foreclosure for the unlucky ex-homeowner).
An unsecured loan does not have any collateral backing it up. Since a lender does not have any collateral to consider, they must gauge a borrower’s credit history, so with no collateral, the lender puts more trust in the borrower’s ability to pay the loan. They may also take into account your income as well which sounds like a pretty big factor. So, if you’ve been paying off your debt ever month with no hiccups and make a ton of money, then you’re more likely to be approved for an unsecured loan.
Why Does it Matter?
With a secured loan, you typically can get a better loan agreement than an unsecured loan, meaning you will have access to lower APRs as well as a greater loan amount in some cases. Additionally, you have a better chance of being approved for a loan in the first place if you have collateral. Of course, this all comes with the risk that you could someday lose your car or house.
With an unsecured loan, you could still get a low APR and have good chances to be approved, but it is typically much harder to do. When a lender considers giving out an unsecured loan, they rely on a borrower’s creditworthiness, or credit score, to determine whether it is a worthwhile investment. Why? They do not have any collateral to fall back on later if need be. If you have an excellent credit score, then you are more likely to get an ideal, unsecured loan deal. If you don’t have good credit, then you may be pushed to find collateral if you want the best terms. If you don’t have collateral, then you’ll either be refused the loan or be forced to accept a worse deal.
There it is. There are two main types of loans, and they both have different stipulations to keep in mind. You can still get the same rates from both loans, but lenders require different things in either scenario. What would you rather have? I would rather build an excellent credit history and just go with an unsecured loan, but that scenario is way easier said than done!