by Robin Hartill, CFP®
Senior Editor
A secured loan is a type of loan backed 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 collateral. 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 aren’t backed by assets you own. But if you have bad credit or a limited credit history, your lender may require you to put down collateral in order to borrow money.
In this article, we’ll explain what is a secured loan, the differences between secured vs. unsecured loans and the pros and cons of a secured loan.
A secured loan is a type of loan where you pledge financial assets as security so that a bank or credit union will lend you money. If you don’t make payments according to the loan contract, the lender can take those assets. A secured loan can be backed by assets like real estate, a vehicle, savings account, cash deposit or business inventory.
Secured loans are commonly used to finance major purchases, like a home or vehicle. But it’s also possible to obtain 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 low credit score, your bank requires collateral. Let’s say you own your car outright, and it’s worth $10,000. You could use your car as collateral to get a secured personal loan. The bank will put a lien on your car (or any other asset you’ve pledged), which gives it a legal claim to the financial asset.
There’s less risk to the bank. If you fail to make monthly payments, the bank can take possession of your car and sell it. But the risk is greater to you because you could lose your car if you default. If you use that car to commute to and from work or for 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 claim to your car or any other asset you used to borrow money.
Keep in mind that there’s still a risk to 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. Defaulting on the loan will make borrowing money much more difficult in the future.
The IRS prohibits using 401(k) or individual retirement account (IRA) money as loan collateral. However, it’s possible to take a 401(k) loan if your plan allows it.
Some common types of secured loans include:
Some less common (and also risky) types of secured loans include:
While a secured loan is backed by collateral, an unsecured loan isn’t backed by personal assets, like 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, because you haven’t pledged valuable collateral that your bank can seize, the financial risk is greater for the lender.
Unsecured loans usually have higher interest rates than secured loans because of the greater risk involved. Compared to unsecured loans, secured loans typically have higher borrowing limits.
Some common types of unsecured loans include:
If you’re trying to decide between secured and unsecured loans, here are some secured loan pros and cons to consider:
A mortgage is an example of a secured loan. The property that you finance serves as collateral. If the borrower defaults, the bank can foreclose on the home. Other types of secured loans include home equity, car notes, business loans and some credit cards and personal loans.
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 loan terms.
A secured loan is a type of loan that’s backed by property, like a house or a car, that the lender can repossess and sell to get its money back if you don’t make loan payments.
Examples of a secured loan include mortgages, auto loans, boat loans, secured credit cards and home equity lines of credit (HELOCs).
You can get a secured loan through many financial institutions, including traditional banks, credit unions and online lenders.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected]
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