%%title%% · %%sitename%% What is a secured loan and how do they work?

A secured loan is a type of loan secured by collateral that your lender can seize if you don’t make payments. A mortgage is one of the most common types of secured loans. Your home is the guarantee. If you don’t make your mortgage payments, your lender will start the foreclosure process to seize your home.

Most personal loans are unsecured loans, meaning they are not secured by any assets you own. But if you have bad credit or a limited credit history, your lender may ask you to post collateral in order to borrow money.

In this article we will tell you what a secured loan is, the differences between secured vs unsecured loans and the pros and cons of a secured loan.

What is a secured loan?

A secured loan is a type of loan where you pledge financial assets so that a bank or credit union will lend you money. If you don’t make payments according to the loan agreement, the lender can take those assets. A secured loan can be backed by assets such as real estate, vehicle, savings account, cash deposit or business inventory.

Secured loans are commonly used to finance major purchases, such as a home or a vehicle. But it’s also possible to get a secured loan for virtually any purpose.

Suppose you need to borrow $5,000, so you apply for a personal loan. But because you have a weakness credit score, your bank requires a guarantee. Let’s say you own your car and it’s worth $10,000. You could use your car as collateral for a secured personal loan. The bank will put a lien on your car (or any other asset you have pledged), which gives them a legal right to the financial asset.

There is less risk for the bank. If you don’t make your monthly payments, the bank may take possession of your car and sell it. But the risk is greater for you because you could lose your car in the event of default. If you use this car to get to work or for your business, you could jeopardize your financial health.

But as long as you repay the entire loan amount as agreed, the lien will be removed. The bank will no longer have a legal right to your car or any other property you used to borrow money.

Keep in mind that there is always a risk for you, even when you take out an unsecured loan. If you don’t make monthly payments, your credit score will drop. Eventually, the account will be sent to collections. Failure to repay the loan will make it much more difficult to borrow money in the future.

Pro tip

The IRS prohibits the use 401(k) Where individual retirement account (IRA) money as loan collateral. However, it is possible to take out a 401(k) loan if your plan allows it.

Examples of secured loans

Some common types of secured loans include:

  • Mortgages: With home loans, the home is the collateral. If you don’t make payments, your lender will foreclose on the house.

  • Home Equity Loans: If you own your home and have built up equity, you can use that equity to get a secured loan in the form of a home equity loan or a home equity line of credit (HELOC). But you risk losing your home if you miss home equity loan payments because your property is collateral.

  • Car credits: If you are financing the purchase of a vehicle, the vehicle is the collateral. If you miss payments, the lender can repossess your car. The same applies if you have taken out a motorcycle or boat loan.

  • Secure bank cards: You may be offered a secure credit card if you have been declined for a regular credit card due to a low credit score or limited credit history. You deposit a cash deposit as financial protection with the credit card issuer. This deposit then becomes your line of credit.

  • Personal loans: Some personal loans are secured loans. A lender may require borrowers to use their savings accounts or a certificate of deposit (CD) as collateral, especially if you are borrowing money and your credit is poor.

  • Business loans: Business loans are often backed by collateral such as equipment, inventory, furniture or real estate. If the company defaults, these assets can be seized by the lender.

Some less common (and also risky) types of secured loans include:

  • Car title loans: You can use your car as collateral for a secured loan if you own it or have capital. However, these loans are generally short term, usually for 30 days or less. They are also extremely expensive, with annual percentage rates, or APR, from 250% to 300%. A loan secured by your car title also puts you at risk of losing your transportation.

Secured or unsecured loans

While a secured loan is backed by collateral, an unsecured loan is not backed by personal assets, such as a property, vehicle, or bank account. Your lender can still sue you if you don’t repay the loan. You can also damage your credit if you don’t pay as agreed. However, since you haven’t pledged valuable collateral for your bank to seize, the financial risk is greater for the lender.

Secured loans

Unsecured Loans

Backed by guarantees

Not backed by guarantees

More risky for the borrower

More risky for the lender

Higher borrowing limits

Lower borrowing limits

Lower credit score requirements

Higher credit score requirements

Lower interest rates

Higher interest rates

Unsecured loans generally have higher interest rates than secured loans due to the higher risk involved. Compared to unsecured loans, secured loans generally have higher borrowing limits.

Some common types of unsecured loans include:

  • Student loans: Although student loans are not secured by personal assets, you generally cannot repay them through bankruptcy.

  • Personal loans: A Personal loan can be a secured or unsecured loan, but obtaining an unsecured personal loan usually requires good credit.

  • Debt consolidation loans: A debt consolidation loan is usually an unsecured loan that you use to pay off higher interest debt, especially credit cards. However, many require a credit score in the mid-600s.

  • Payday Loans: More payday loans, also known as cash advance loans, are unsecured loans. However, you may need to authorize automatic transfers from your bank account or provide a check for the lender to deposit when payment is due.

  • Buy now, pay later: Buy now, pay later finance credit — that’s financing from companies like After-payment and Klarna — is a type of unsecured loan.

Benefits of Secured Loans

If you’re trying to choose between secured and unsecured loans, here are some pros and cons of secured loans to consider:

  • Opportunity to make a major purchase: Secured loans allow you to finance major purchases, such as a house, car or motorcycle. Unsecured personal loans have significantly higher interest rates and lower loan limits, making them difficult to use for a major purchase.

  • Better access to credit: A secured loan means that the lender can get their money back if the borrower does not make the payments. Therefore, people who otherwise would not qualify for a loan due to their credit history can often borrow money.

Disadvantages of secured loans

  • Puts your assets at risk: If you do not repay your secured loan, your collateral will be seized. You could lose your house, your car, your savings or your valuables.

Frequently Asked Questions (FAQs)

What is an example of a secured loan?

A mortgage is an example of a secured loan. The asset you are financing serves as collateral. If the borrower defaults, the bank can foreclose on the house. Other types of secured loans include home equity, car notes, business loans, and some credit cards and personal loans.

Is a secured loan a good idea?

A secured loan is a good idea in some circumstances because it can lower your interest rate and help you get approved to borrow money when you wouldn’t otherwise qualify. However, a secured loan can also be risky because you lose your collateral if you don’t pay according to the terms of the loan.

What is a secured loan in simple terms?

A secured loan is a type of loan secured by real estate, such as a house or car, that the lender can repossess and sell to get their money back if you don’t repay the loan.

What are 5 examples of a secured loan?

Examples of secured loans include mortgages, auto loans, boat loans, secured credit cards, and home equity lines of credit (HELOC).

Where can you get a secured loan?

You can get a secured loan from many financial institutions, including traditional banks, credit unions, and online lenders.

Robin Hartill is a Certified Financial Planner and Senior Writer at The Penny Hoarder. She writes the personal finance advice column for Dear Penny. Send your tricky money questions to AskPenny@thepennyhoarder.com.

This was originally posted on The Penny Hoarder, which helps millions of readers around the world earn and save money by sharing unique job opportunities, personal stories, giveaways and more. The Inc. 5000 ranked The Penny Hoarder as the fastest growing private media company in the United States in 2017.

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