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When borrowing money, the types of loans available generally fall into two categories: secured and unsecured debt. A secured debt uses collateral from the borrower—like a home, car, or savings account—to back the loan, making it less risky for the lender. If the borrower is unable to repay the loan for any reason, their asset can be used by the lender to recover the money. In contrast, an unsecured debt is a loan that is not backed by any collateral.
Some of the most common types of secured debt use your home or car as an asset to secure the loan. A mortgage, for example, is a secured loan because the lender can legally seize the property and sell it to recoup any money owed if you default on your mortgage payments. A home equity loan is another type of secured loan that uses your house as collateral. In this situation, you borrow money based on the difference between what your home is worth and what is still owed on your mortgage—also known as home equity. If you fail to repay the loan, your house is the collateral used by the lender to recover their money.
Auto loans are another form of secured debt, because the car can be repossessed by the lender if you are unable to make your payments. Many people also choose to refinance an auto loan for a lower interest rate after establishing a certain amount of equity in the car. In an auto-refinance loan, a lender repays the balance of your original auto loan and replaces it with a new loan for more money. You, the borrower, receive the monetary difference and are able to enjoy lower interest payments for the duration of the new loan. Your car is used as collateral to secure the loan in the event that you default on its repayment.
Some of the most common types of unsecured debt are credit card debt and personal loans. Credit cards allow borrowing up to a predetermined limit, and they function as a revolving line of credit—where borrowed money is restored to your credit limit as you pay it back, much like a revolving door. By paying your credit card balance in full each month, you can avoid paying interest charges. Otherwise, you’ll pay interest and your balance will roll over into the next month’s billing. Most credit cards do not require collateral, making them an unsecured loan. The loan offer and terms are instead based on your credit history and score, which can be negatively impacted if you fail to make timely payments or default on your loan.
An unsecured personal loan is usually obtained through your bank, credit union, or an online lender. This type of loan is also called a “signature loan”, because if you have an existing account with the financial institution and a good credit history, a signature is usually the only other thing required to get one.
The major difference between secured and unsecured debt is the presence (or absence) of collateral, and there are pros and cons associated with both types.
With secured debt, the obvious disadvantage is that you stand to lose an asset if you are unable to repay your loan for any reason. Particularly if the collateral for the loan is your home, car, or a savings account, this could be a major loss. As with any loan, your credit score and ability to borrow funds in the future can also be negatively impacted if you don’t repay on time or at all.
There are also plenty of benefits associated with secured loans. If your credit history is less than ideal, it can be easier to qualify for a secured loan, since the collateral lessens the risk for your lender. The terms of your loan are also likely to be more favorable since the lender has a better chance of being repaid, meaning that you could have a lower interest rate, higher borrowing limit, and longer term for repayment.
An unsecured debt doesn’t require any collateral, so your home, car, or other valuables are not at risk if you find yourself unable to repay the loan. Unsecured debt is also generally accompanied with a shorter repayment term, which can be helpful for quickly improving your credit score.
Because unsecured debt is riskier for lenders, however, this type of loan can be more difficult to obtain. Your credit history and score are used to determine eligibility, and even if you are approved, the terms of the loan may not be as beneficial as those offered with a secured loan. Unsecured loans generally have higher interest rates and lower borrowing limits. If you fail to repay your loan, you’ll also face the consequences of a damaged credit score and difficulty borrowing money in the future.