Everyone knows what mortgage and car loans are, but doesn’t necessarily understand how they work. Mortgage and car loans are secured loans, which means they’re secured by collateral. Meanwhile, unsecured loans don’t require collateral, but both types of loans can affect your credit score if you default on them or forget to make payments. Businesses and individuals can take out secured loans in which a lender requires collateral for funding a purchase.
How Do Secured Loans Work?
With a secured loan, you’re required to use collateral. For example, mortgage loans are secured loans secured by the house. With car loans, the vehicle serves as collateral. If you default on the loan, the bank or lender has the right to seize the asset.
Individuals get secured loans for various reasons, ranging from borrowing money for weddings to large purchases like paying for their children’s education. A few examples of secured loans include the following:
- Mortgage loans
- Car loans
- Second mortgages
- Secured credit cards and lines of credit
- Car title loans
- Life insurance loans
- Bad credit loans
Of course, the most common secured loans are mortgage and car loans, which are secured by the assets a borrower is trying to purchase. Meanwhile, other types of secured loans work differently. Your savings, investments, and other types of bank accounts can also be used to secure loans.
For example, if someone takes out a secured line of credit, their collateral won’t be a physical asset like their car or home. Instead, the lender will ask for a deposit to hold as collateral, and if the person defaults on the loan, they’ll lose their deposit. If you have poor credit, a credit card company may still give you a credit card, but it might be secured until you prove that you’ll pay the balance on time every month, in which case your deposit will be returned, and your credit card will become unsecured.
Secured Business Loans
Business loans are often secured by collateral. For example, a manufacturing business may take out an equipment loan, in which case the equipment serves as collateral. In this case, as long as the business repays the loan, it won’t lose the purchased equipment. However, if they default on the loan, they’ll lose the equipment and any money they’ve already spent paying back the loan.
Depending on the lender, a business may be required to sign a personal guarantee when taking out a secure business loan. This guarantee is meant to make you liable for business debts, so if you fail to repay the loan, it won’t only affect your business credit history. Therefore, it can have detrimental effects on your credit score and finances.
Pawnshop and Car Title Loans
Pawnshop and car title loans aren’t the same, but they’re similar. Car title loans allow you to borrow money against your car, while pawnshop loans allow you to borrow money against anything of value, such as jewelry. Unfortunately, these loans also carry interest, and that interest is at the discretion of the pawnshop or car title loan provider. Therefore, you can expect to pay hefty interest for borrowing money.
In addition, if you fail to repay these loans, you’ll lose your car or other personal assets. Most people should avoid these types of loans because they’re short-term and difficult to pay back on time. Since many of the things people pawn are personal belongings passed down through their families, such as jewelry and other expensive items, it’s usually not worth the risk. In addition, even if you need money fast, you may not be able to pay back the loan, and pawnshops don’t care since they want you to default on the loan so they can make more money by selling your assets.
Life Insurance Loans
Life insurance loans allow you to borrow money against your life insurance policy, in which case the cash of the policy is the collateral. You can repay the loan during your lifetime or let the loan be deducted from the death benefit paid after your death, but neither option is ideal for most people. If you don’t want to potentially leave your children or spouse with less money after your death, avoid these loans as best you can.
Bad Credit Loans
Bad credit loans are personal loans for individuals with low credit scores, and lenders often require cash security like secured credit cards and lines of credit. These loans may be ideal for individuals trying to improve their credit but still need a loan for large purchases. However, they often come with higher interest rates and fees because of the borrower’s low credit score.
Who Offers Secured Loans?
Secured loan providers are banks, credit unions, and mortgage and online lenders. Of course, it depends on the type of secured loan you need. For example, you wouldn’t go to a mortgage lender if you needed a car loan. Before you choose a secured loan, consider these factors:
The type of collateral required to secure the loan
- Interest rate
- Loan amounts
- Credit score, and income requirements
Are Secured Loans Better Than Unsecured Loans?
The type of loan that’s best for you will depend on several factors, including your credit score, collateral requirements of the loan, and loan terms. However, in most cases, unsecured loans are better than secured loans because they come with fewer risks to the borrower. When you use an unsecured loan, you aren’t risking losing collateral. However, sometimes you don’t have a choice. Mortgage and car loans are always secured, so if you don’t repay the loan, you’ll lose your car or home. However, when it comes to personal loans, you have options. Still, interest rates with secured loans are lower because they’re less risky for lenders, so if you want to pay less over the life of the loan, secured loans might be right for you.
Ultimately, both options have their pros and cons. In some cases, it’s best to avoid loans altogether unless they’re necessary. Secured loans have lower interest rates, but lenders can seize your collateral if you fail to repay. Meanwhile, unsecured loans don’t require collateral, so if you fail to repay, only your credit score will be affected.