If you have a mortgage or an auto loan, you likely have a secured loan. You've agreed that if you can't pay off the loan, the lender has the right to take your home or vehicle.
A personal loan, on the other hand, can be secured or unsecured. But what are the primary differences between these two types of loans? And how do they affect you?
1. Secured loans require collateral.
The house or car that you put up to secure your mortgage or auto loan is collateral for that loan. It acts as a guarantee so if you can't repay the loan, there's something of value for the lender to collect in place of repayment.
However, collateral doesn't always need to be the thing you're purchasing with the loan. Some secured loans accept other forms of collateral such as money in your savings account or a Certificate of Deposit.
2. Unsecured loans put your income, possessions and savings at risk.
Bob Hirth, assistant professor of management at the Earl N. Phillips School of Business in North Carolina, says that if you default on an unsecured loan, the lender can attempt to get a judgment for nonpayment. A judgment is a court order that is entered against you for a specific amount of money if the lender files a lawsuit for nonpayment and proves to the court that you owe it that money.
If you don't respond or appear in court, the judge can still issue a judgment against you. If the lender succeeds, your wages could be garnished, money might be taken from your bank account or some of your possessions might be seized and auctioned.
Some federal benefits, including Social Security and veteran's benefits, are exempt from wage garnishment. Depending on which state you reside in, there may also be exemptions for your primary residence, vehicle and personal property or savings.
On the other hand, if you can't pay off a secured loan, Hirth says that the lenders will take the collateral first. If the collateral isn't worth as much as the amount you owe - if your car has been in a wreck, for example - then the lender might attempt to get a judgment for nonpayment.
3. Unsecured loans generally require better credit.
Because lenders take on less risk with secured loans, they typically don't require borrowers to have as good of a credit score as they require for an unsecured loan. If you have a limited credit history or a low score, it will likely be easier for you to get a secured loan than an unsecured loan. In addition, you may also be able to borrow more money with a secured loan.
Plus, even with a fairly good credit score, you might not get approved for an unsecured loan. Other criteria, such as your debt-to-income ratio and your employment status, can often come into play.
4. Interest rates are often higher on unsecured loans.
You might be able to get relatively good terms - a low-interest rate and favorable repayment period - with an unsecured loan. Some online lenders, in particular, offer low rates. However, unsecured loans typically come with higher interest rates than secured loans.
For example, we compared personal loan rates from Wells Fargo for a $10,000 unsecured loan. Using the same ZIP code and a 12-month term, the lowest annual percentage rate for an unsecured loan was 6.236 percent. For a secured loan, it was 5.479 percent.
Both types of loans can build credit.
Credit coach Jeanne Kelly says, "If you've never had credit or have a low credit score, you may be able to start building your credit history with a secured loan." Unsecured loans can serve a similar purpose, but it's harder to get approved.
The length of your credit history is one factor in your credit score, and opening the loan establishes a new line of credit. The loan may also help your credit by adding to the variety of credit accounts you have and increasing the overall available credit to your name. It's important to make on-time payments, one of the most important factors in your credit score calculation. If you make a late payment, your score may drop, you might have to pay a fee and the late payment may remain on your credit report for seven years.
Make sure the lender is reporting the activity on the loan account to at least one of the credit bureaus. You can do this by requesting a copy of each of your three credit reports from AnnualCreditReport.com or by checking your credit report at Credit Karma.
If your payments aren't being reported you can contact the lender and request they begin reporting them, but the lender isn't required to do so. A better route is to contact the lender before taking out a loan and ask which bureaus, if any, they report to. If you can find a good loan offer from a lender that reports to all three bureaus that may be best.
If you're looking for a personal loan, there's a lot to consider. With either a secured or unsecured loan, you may be offered different interest rates, fees, and repayment periods depending on the lender you choose, so be sure to compare offers carefully.
Secured loans generally have a lower interest rate and potentially larger loans amount and are often easier to get, but you put other assets at risk when you get one. If you have a strong financial profile or you don't have any collateral, you might prefer an unsecured loan. But you should be prepared to pay a little extra in interest if you take this route.
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