What Is a Secured Loan and How Do They Work?
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.
What Is 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.
Examples of Secured Loans
Some common types of secured loans include:
- Mortgage loans: With home loans, the home is the collateral. If you don’t make payments, your lender will foreclose on the home.
- Home equity loans: If you own your home and you’ve built equity, you can use that equity to obtain 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 the collateral.
- Car loans: If you finance a vehicle purchase, the vehicle is the collateral. If you miss payments, the lender can repossess your car. The same applies if you’ve taken out a motorcycle or boat loan.
- Secured credit cards: You may be offered a secured credit card if you’ve been denied for a regular credit card because of a low credit score or limited credit history. You put down a cash deposit as financial protection to the credit card issuer. That deposit then becomes your credit line.
- 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, particularly if you’re borrowing money and have poor credit.
- Business loans: Business loans are frequently backed by collateral, such as equipment, inventory, furniture or real estate. If the business 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 outright or you’ve built some equity. However, these loans are usually short term, usually for 30 days or less. They’re also extremely expensive, with annual percentage rates, or APRs, of 250% to 300%. A loan backed by your car title also puts you at risk of losing your transportation.
- Pawn shop loan: Pawn shops allow you to use valuables like jewelry or electronics as collateral to borrow money.
Secured vs. Unsecured Loans
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.
|Backed by collateral
|Not backed by collateral
|Riskier for the borrower
|Riskier 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 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:
- Student loans: Though student loans aren’t backed by personal assets, you typically can’t discharge them via bankruptcy.
- Traditional credit cards: People with good credit scores can typically qualify for an unsecured credit card. But credit cards have high interest rates. The national average APR is just north of 16%.
- Personal loans: A personal loan can be a secured or unsecured loan, but obtaining an unsecured personal loan typically requires good credit.
- Debt consolidation loans: A debt consolidation loan is typically an unsecured loan that you use to pay off higher-interest debts, particularly credit cards. However, many require a credit score in the mid-600s.
- Payday loans: Most payday loans, also known as cash advance loans, are unsecured loans. However, you may have to authorize automatic transfers from your bank account or provide a check that the lender can deposit when the payment is due.
- Buy now, pay later loans: Buy now, pay later financing credit — i.e., the financing offered by companies like Afterpay and Klarna — is a type of unsecured loan.
Secured Loan Pros
If you’re trying to decide between secured and unsecured loans, here are some secured loan pros and cons to consider:
- Ability to make a major purchase: Secured loans allow you to finance major purchases, like a home, car or motorcycle. Unsecured personal loans have significantly higher interest rates and lower loan limits, making them difficult to use on a big purchase.
- Greater access to credit: A secured loan means that the lender can get its money back if the borrower doesn’t make payments. As a result, people who wouldn’t otherwise qualify for a loan based on their credit history can often borrow money.
- Lower interest rates: Secured loans tend to have lower interest rates than unsecured loans because there’s less risk to the lender.
Secured Loan Cons
- Requires upfront collateral: A secured loan requires you to pledge assets as collateral to borrow money. You may not have assets to use if you need to borrow money in an emergency.
- Puts your assets at risk: If you don’t make secured loan payments, your collateral will be seized. You could lose your home, car, savings or valuables as a result.
- Fewer options: If you’re seeking a personal loan or credit card, you’ll typically have a lot more options once you qualify for an unsecured loan.
Frequently Asked Questions (FAQs)
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].