Secured vs. Unsecured Loans: Understanding the Differences

The difference between a secured loan and an unsecured loan is not just collateral requirements. Each of these financial resources offers multiple benefits and drawbacks. Here are the specific requirements and types of loans offered to help you find the best one for your situation.

What are secured loans?

Secured loans are loans that are guaranteed with a physical item. The lender approves the loan because the borrower has used some type of property as collateral. If you don't pay back the loan, the lender can take the property to recoup its losses. 

What are unsecured loans?

Unsecured loans aren’t guaranteed by a physical item. The lender assesses your creditworthiness and ability to repay the loan when it determines your eligibility. You don’t have to put up any collateral, which means that the lender potentially risks losing money if you can’t repay. 

Key differences between secured and unsecured loans

Loans can be either secured or unsecured, but the differences don’t stop there. 

Collateral requirements

The collateral requirement is one of the most important differences between secured and unsecured loans. Collateral is a physical item, including cash, that a borrower can forfeit if they don’t repay their secured loan. Unsecured loans don’t require collateral. For example, a loan on a boat uses the vessel as collateral but an unsecured personal loan for home renovations or to pay down debt requires no personal property as collateral.

Interest rates and terms

Interest rates and terms are determined by the lender. Typically, a secured loan has a lower interest rate than an unsecured loan. Collateral limits the risk for secured loans; unsecured loans use higher interest rates to compensate for a lack of collateral. Terms may be shorter on unsecured loans as well so the lender doesn’t have to wait as long to receive full repayment. 

Approval process and credit considerations

The approval process for unsecured and secured loans typically follows the same format. The lender will review your creditworthiness when you apply to determine whether to approve you and for what terms. Lenders will typically look at a borrower’s:

• Credit score
• Credit history
• Debt-to-income ratio
• Outstanding loans

Credit considerations in the approval process are slightly different. A secured loan assesses the value of your collateral; the value of the collateral can help you qualify with a lower credit score. Because unsecured loans don’t require collateral, lenders may have stricter standards (like requiring a higher minimum credit score and setting a higher interest rate).

Risks and benefits for borrowers

All loans have advantages and disadvantages. Keep in mind that benefits don’t always outweigh the risks. For example, getting a lower interest rate is appealing, but putting up collateral for a secured loan should be a serious consideration. 

Here are some factors to consider for secured loans:

Here’s what to consider before you take out an unsecured loan:

Common types of secured loans

Taking out a secured loan usually involves a substantial commitment and is typically one of the largest financial purchases a person makes. Installment loans, like car loans, are common types of secured loans, but revolving loans, like a home equity line of credit (HELOC), can also be secured.

Mortgages

Mortgages, like an FHA loan, are secured loans that use the home as collateral. The lender keeps the deed to the home until the mortgage is paid; if the borrower defaults, the lender can foreclose on the house. A home equity loan is also a secured loan; the home is used as collateral. Even though the property is used as collateral, mortgages are significant investments and a lender may require a minimum credit score for a home loan before lending such a large amount of money.

Auto loans

A car loan is similar to a home loan: The item you’re financing is used as collateral. If you default on your auto loan, the lender can repossess the vehicle. You only gain ownership of the vehicle when the loan is repaid. 

Secured personal loans

You can take out a secured personal loan to finance home renovation projects or fund a business and offer other types of collateral. To secure your personal loan, a lender may require a cash deposit, stocks, bonds, or other personal property be used as collateral. 

Common types of unsecured loans

Unsecured loans don’t require collateral. These loans can be as small as a few hundred dollars or well into the tens of thousands. Installment loans, like student loans, and revolving loans, like credit cards, can be unsecured.

Personal loans

Personal loans are unique in that they can be used for a wide range of financial needs, including paying medical bills, funding a large purchase, or consolidating debt. These loans may have fixed or adjustable interest rates. 

Credit cards

Credit cards are considered revolving loans. Instead of receiving a one-time lump sum, you’re free to keep using the credit card until you hit its preset credit limit. Many people take advantage of credit cards that offer initial periods of low or no annual percentage rate (APR), which can help you save on interest. 

Student loans

Student loans allow you to finance your education. These loans are available through public, private, and government agencies. Federal student loans may have repayment schedules delayed until after you graduate. They may also be subsidized, which means the loans do not accrue interest when the borrower is actively in school or in a deferment period. 

James Sias, head of mortgage revenue at Fifth Third Bank, suggests that potential borrowers consider the long-term impact of high interest rate debt from unsecured loans. 

“Borrowing to fund short term career or lifestyle goals might seem like a good idea at first, but debt accumulates quickly, especially when factoring in high interest rates from unsecured loans and credit cards,” Sias says. “You need to consider carefully whether the future earning potential from your investment (education, career training, etc.) will exceed the debt incurred over the long term.”

Sias suggests exploring all possible funding avenues, such as grants, scholarships, and employer tuition reimbursement, before turning to high-cost options like credit cards or loans to pay for educational opportunities. 

As with all loans, Sias recommends borrowing only what’s necessary, budgeting conservatively, and having a clear repayment strategy. 

How to choose between a secured and unsecured loan

Secured loans and unsecured loans each have their own approval criteria, benefits, and risks. 

Assessing your financial situation

Before applying for any loan, always check your credit score and report. Removing errors on your credit report and taking steps to increase your credit score can help you qualify for lower interest rates. 

“Approval for unsecured loans is heavily based on your credit score and financial history, whereas secured loans are typically easier to obtain if you have a lower credit score, as the collateral reduces the lender’s risk,” Sias says. “However, defaulting on either type of loan can negatively impact your credit score.”

Evaluating loan purposes and amounts

Loans are helpful financial resources, but are not always the best tool for certain situations. Both secured and unsecured loans may only be used for certain purposes; some are limited to specific amounts. 

For example, a credit card can be used for a wide variety of purposes, but you may not get a high enough credit limit to fund your goal. Similarly, a mortgage loan may cover the purchase of a home but you might be unable to get the amount increased to cover planned renovations. 

Considering interest rates and repayment terms

Interest rates and repayment terms will vary based on the borrower’s eligibility and the lender’s preference. However, Sias notes that there is usually a correlation between certain types of loans and their interest rates and repayment terms. 

“Because secured loans are backed by collateral, they typically offer lower interest rates and more favorable terms,” Sias says. “Unsecured loans, which carry higher risk for lenders, typically have higher interest rates and may come with shorter repayment periods.”

Before choosing a loan type, it’s a good idea to compare interest rates against the market’s current average rates. 

Understanding potential risks and benefits

The potential risks and benefits of loans aren’t always obvious. For example, collateral requirements for secured loans pose both advantages and disadvantages for borrowers. Collateral can help a borrower qualify for a loan, though lenders can seize the collateral if a borrower fails to repay the loan.

It’s a good idea to look at all factors involved when choosing between a secured or unsecured loan. Though you may be able to lower your interest rate by a percentage point if you put collateral down, the risk of losing your property may not be worth it. 

“A secured loan can provide lower costs over the life of the loan, but comes with the risk of losing your asset if you default,” Sias says. “Unsecured loans offer more flexibility since there is no asset at stake, but they often have stricter approval requirements and higher fees and interest costs.”