Sure, you could mow acres of lawn with a weedeater, dig a hole with a pitchfork or nail a screw with a hammer. You’d be turning an old adage on its head by working harder, instead of smarter, however. Like tools, loans are much more effective, and easier to maintain, when you wield the right loan product for the job at hand – whether that’s buying a new car, taking out a mortgage or consolidating high-interest credit card debt.
Knowing what an unsecured loan is and how it compares to a secured loan, can help you choose the right loan type, so you can do things like sand down high interest rates, hammer away at debt or take an ax to large expenses to chop them into manageable monthly payments.
So what is an unsecured loan exactly? What is a secured loan? And what’s the best way to take advantage of them?
Consider this your quick-start guide to the characteristics of secured and unsecured loans, as well as a primer on how you can use them to repair or renovate your finances.
What a Secured Loan Is — and the Best Ways to Use It
When you think of “secured loans,” think collateral. Collateral provides lenders security against non-payment, or “default.” Instead of having to navigate the legal system to recoup a loan that wasn’t paid in full, the lender can take possession of the collateral a borrower submitted to guarantee the loan.
Having to put up a car, real estate or other valuable assets as collateral for a loan is a sobering thought. But you can’t blame lenders for wanting to ensure an applicant is serious about repaying the loan.
Common types of collateral for secured loans: automobiles, real estate, investments, insurance policies and cash accounts.
Backing a loan with collateral not only affirms your commitment to repayment — it can also raise your chances of approval for that loan, especially if there’s plenty of room for your credit score to improve. With less risk to the lender, it’s often easier to land a secured loan than an unsecured loan, though the latter is still the most common type of personal loan.
Check out some of these common use cases for secured loans:
- Financing a new car: You don’t need pristine credit to buy a car, since the car itself can serve as collateral.
- Mortgaging a home: Just like financing a car, you can buy a home with a secured loan.
- Building credit: If you have bad credit or none at all, you can use your own money as collateral to get a small line of credit from a bank. With responsible use, that credit line could grow.
- Emergency money: If you need money and don’t have great credit, you can borrow money by using collateral such as a car title or jewelry.
- Business loans: If you don’t qualify for an unsecured loan, or need more than offered, you could land a secured loan by backing it with high-value assets, such as real estate or business inventory.
Pros of Secured Loans:
- Lower interest rates
- The potential to borrow larger amounts
- Easier to qualify for, since they involve less risk to the lender
- Lower credit score requirements
Cons of Secured Loans:
- Approval could take longer as assets are reviewed
- Have to leverage assets, risking repossession or foreclosure in cases of loan default
- Smaller loans or shorter terms may not be available
In the approval process for a secured loan, lenders also factor in your creditworthiness: Your debt-to-income ratio, credit scores, the value of your assets, employment status and the health of your accounts. These factors typically weigh more in the application process for unsecured loans.
What an Unsecured Loan Is and How to Use It
It’s what it sounds like, yet not exactly so.
Unsecured loans don’t require the security of collateral. Instead, a potential lender will review your creditworthiness to determine if they’ll extend you an unsecured loan.
While an unsecured loan doesn’t require you to put up collateral like a secured loan, the bank still has recourse to recoup the loan, should you fail to repay it in full. In their toolkits, banks have legal options, such as lawsuits and wage garnishment, which they can use to protect themselves against defaulted loans.
Here are some common use cases for taking out an unsecured loan:
- Debt consolidation: A single lower-interest loan to consolidate all of those high-interest credit cards and other debt.
- Emergency money: A solid emergency fund isn’t always enough, but a significant line of credit can bail you out in an emergency.
- Big-ticket items: Spread out big purchases to fit a large item into your monthly budget.
- Buying a car: You can use a personal line of credit to purchase an automobile from a private seller.
- Home improvement: Homeowners can use a personal loan with a fixed interest rate to make home improvements without using the home as collateral, which is required with other options, like a HELOC.
- Weddings: Some couples opt for a personal loan to cover large expenses, like weddings.
Pros of Unsecured Loans:
- No need to leverage any assets as collateral
- Faster approval process, since there’s no need to evaluate assets
- The potential to take smaller loans
Cons of Unsecured Loans:
- Higher interest rates
- Higher credit scores required
How a Secured or Unsecured Loan Can Impact Your Credit Scores
Because it’s a soft credit pull, there’s no impact to your credit score for looking into a secured loan or an unsecured loan. But once you actually apply, your credit score could take a mild to moderate hit. That hit to your credit scores may come from the hard inquiry to your credit file, as well as the rise in debt that comes from using the loan.
But if you’re seriously considering a personal loan, then you probably aren’t shortsighted and can appreciate the beauty of the long game.
In the long run, that hard inquiry will fall off your credit file. And if you keep up with your loan payments, your score could begin to trend upward in a matter of months.
Paying that loan every month will help improve your payment history. And if you’re using that loan to pay off credit card debt, you could score points by lowering your debt-to-credit ratio.
Proving you can responsibly pay off a loan is one of the more impactful things you can do to improve your credit scores. And it could help you secure even better loan terms the next time you go looking for a secured or unsecured loan.
Shopping for Secured and Unsecured Loans
So now that you’re up to speed on the key distinctions between a secured versus unsecured loan, there’s still a little more work you need to do to secure the funds you need.
You might find it tempting to jump onto the first pre-approved offer from lenders with names you’ve heard of, especially if the terms are solid, but you could be doing yourself a disservice if you don’t compare offers.
You can compare secured loans, unsecured loans, lines of credit and more to find the best available option for you by using a loan-comparison tool like Fiona. Fiona searches the top online lenders to match you with a personalized loan offer in less than 60 seconds.
If your credit score is at least 620, its platform can help you borrow up to $250,000, with fixed rates starting at 2.49% and terms from 6 to 144 months.
And don’t worry: Checking to see if you qualify won’t affect your credit score. Plus it’s free, and your information is totally safe — the website uses higher encryption security than many banks. After all is said and done, you could see your money in just a few days.
Just answer a few quick questions here to compare all the best available loan options for you.