Secured vs. Unsecured Loans: What's the Difference?

·6 min read

If you're thinking about borrowing money, knowing the differences between secured and unsecured loans can be helpful.

Secured loans require collateral -- an asset that could be taken from you if you don't repay the lender -- and unsecured loans are backed only by the borrower's credit. The type of loan you choose affects your credit requirements for the loan as well as the interest rates and loan amounts you might get.

Here is a closer look at secured and unsecured loans if you need to decide which kind is right for you.

[Read: Best Personal Loans.]

What Is the Difference Between Secured and Unsecured Loans?

The key difference between secured and unsecured loans is collateral, says Tom Parrish, vice president, head of retail lending product management at BMO Harris Bank.

You're using some form of collateral, such as a car, home or stock, to back up a secured loan, Parrish says.

If you default on the loan, the lender could seize your property and then sell it to pay your debt. Collateral reduces risk for the lender.

Unsecured loans, on the other hand, are supported by the borrower's creditworthiness rather than collateral. They are riskier for lenders than secured loans and may come with higher interest rates and require higher credit scores.

Is a Secured Loan a Good Idea?

While the potential to lose your collateral is a clear drawback of secured loans, there are also distinct advantages over unsecured loans:

-- Larger loan amounts. When you secure a loan with collateral, such as property or cash, you can borrow a lot more than if you don't have collateral, Parrish says.

-- Easier qualification requirements. You might find that you can have a higher debt-to-income ratio -- your debt compared with your income -- than if you were applying for an unsecured loan, Parrish says.

-- Lower interest rates. The interest rate for an unsecured loan could be higher than for a secured loan because the latter has a secondary source of repayment, such as property or cash, says Alice Frazier, president and CEO of Bank of Charles Town in West Virginia and secretary of the Independent Community Bankers of America. More risk is involved in an unsecured loan, Frazier says, and the higher interest rate reflects that.

[Read: Best Debt Consolidation Loans.]

What Types of Secured Loans Can You Get?

Secured loans can come in many forms, such as mortgages, home equity loans or lines of credit, car loans, credit cards, personal loans, savings-secured loans, and title loans. The types of assets you can pledge to qualify are:

-- A home for a mortgage or a home equity loan or line of credit

-- A car for a car loan or secured personal loan

-- A cash deposit for secured credit cards

-- A savings account for a secured personal loan or savings-secured loan

-- A paid-off car or boat for a title loan

People may use loans secured by cash when they have enough savings to pay for an item but don't want to use it, Frazier says. "Maybe they have it in a certificate of deposit and don't want to break that," she says.

What Types of Unsecured Loans Can You Get?

You can get either a line of credit or a lump sum and pay it back in monthly installments. Unsecured loans, also called personal loans, are used for a variety of reasons, including debt consolidation or a major purchase.

A credit card is another type of unsecured loan, as is a student loan.

The major advantage of unsecured loans compared with secured loans is the speed at which you can get approved. Getting a home equity loan could take weeks, but being approved online for an unsecured personal loan or a credit card might take minutes.

"Unsecured loans tend to be faster and easier to obtain, but this convenience comes at the cost of a higher rate," Parrish says.

Secured loans, on the other hand, "tend to have significantly lower rates than unsecured loans but require more documentation and take a longer time to receive funds," he adds.

What Is the Loan Approval Process?

The approval process for secured loans emphasizes slightly different factors than the process for unsecured loans, according to Parrish. Income, credit history and assets are key for secured loans, while FICO score and debt-to-income ratio matter most if you want an unsecured loan.

When underwriting an unsecured loan, Parrish says, "The FICO score helps us understand the customer's likelihood of paying us back based on how they previously managed their credit, whereas the debt-to-income ratio helps us assess the customer's capacity to repay the debt."

For each loan application, Frazier adds, lenders will "look at the amount of debt payments the individual has and compare it to their monthly income."

Each bank sets its own debt-to-income ratio to determine whether a consumer has enough money to make the payments on a new loan, plus cover debts and daily living expenses, she says.

If a lender won't allow a debt-to-income ratio greater than 40%, that means no more than 40% of your gross monthly income can support debt payments, such as credit cards, auto loans and home loans, Frazier says. Gross monthly income is the amount you earn in one month before taxes or deductions are taken out.

So if you made $10,000 per month, your debt payments could be no more than $4,000.

Acceptable credit scores will vary by lender, along with income requirements, which could depend on the size of the loan.

An independent third party, such as a real estate appraiser, could determine the value of the property you might use to secure a loan.

What Are the Risks of Secured and Unsecured Loans?

Both secured and unsecured loans can present risks to borrowers.

With either type of loan, you risk damage to your credit if you default by not making payments.

Even one missed payment can cause your score to drop. If the situation drags on for months, the damage could increase exponentially.

With secured loans, there is another layer of risk: You could lose your home or car. In a default, the lender could foreclose on your home or obtain your vehicle to get back its investment.

Unsecured loans, though, don't allow you to simply walk away. The lender could sue you for the outstanding amount and take it from your wages or bank accounts.

[READ: Best Bad Credit Loans. ]

Is a Secured or Unsecured Loan Better?

The choice between secured or unsecured depends on the loan and your financial needs. For example, you shouldn't expect to get a mortgage without securing the loan with your house.

But if you need to consolidate debt and don't have enough equity to obtain a home equity loan or line of credit, an unsecured personal loan might be your best bet.

"In general, secured loans have more favorable interest rates and terms associated with them, which would benefit most customers," Parrish says. "If the customer does not have collateral/equity or may need to borrow for a shorter period of time, an unsecured loan can also be a great option."

Some consumers secure a home equity line of credit to take advantage of the low interest rates on secured loans, anticipating the need for a major purchase.

"A lot of people do maintain a home quality line of credit and maybe never borrow on it, but it's there, just in case," Frazier says. "If they do have a need, they can get to that quickly."