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

| Money Rates Columnist
min read

older-couple-loansPersonal loans are usually unsecured. Unsecured personal loans are only backed by your promise to repay them - your "personal" guaranty. If you are having a hard time getting approved for an unsecured loan, or you don't like the interest rate the lender offers, consider a secured personal loan. Secured personal loans are backed by collateral - an asset that the lender can repossess if you don't repay the loan.

See today's personal loan interest rates

What Are Unsecured Personal Loans?

Unsecured personal loans are also called signature loans. The idea is that there is no car, house, boat, art collection or whatever for the lender to take from you if you don't repay the loan. Most personal loans are of the unsecured variety.

So, if the lender can't take your assets, how can it be sure that you'll repay? Personal loan providers want to know that you're both willing and able to repay them. Lenders evaluate applicants based on their credit history and score, which shows how they handled debt in the past, and their income, which proves that they are capable of repaying the loan.

Unsecured Personal Loan Rates

If you search for interest rates for unsecured personal loans, you'll see that interest rates vary from roughly 6% to 36%. The reason rates for unsecured personal loans are so unclear is that they're based on current loan rates in general as well as your specific credit profile. The lender has no idea what rate might be appropriate until it reviews your credit standing.

In practice, the rate you pay for an unsecured personal loan depends on two variables - both of which you largely control.

First, the better your credit, the lower your rate.

That's because credit scores are closely related to delinquencies. Research by credit score pioneer Fair Isaac shows that individuals with credit scores from 800 and above have a delinquency rate of about 1%. However, the delinquency rate for those with credit scores between 580 to 669 is about 28%. That's 28 times higher than individuals with top scores. As a lender, you would rather deal with borrowers who represent less risk.

The good news about credit scores is that you can control them. The best way to raise credit scores is to pay bills in full as soon as they are received. This will allow you to avoid late fees and credit dings.

Second, different lenders charge different rates. You need to shop around for the best rate given your credit profile.

Where to Find Unsecured Personal Loans?

Unsecured personal loans are widely available. Major sources include banks, credit unions, peer-to-peer lenders, online lenders, apps, friends and family. To get the best deal on an unsecured personal loan, contact several competing providers, give them all the same information (loan amount, term in years, estimated credit score, income and debts).

What Happens if You Don't Repay an Unsecured Personal Loan?

Just because a loan is unsecured doesn't mean lenders have no recourse if you walk away from the debt. Expect one of more of the following repercussions if you fail to pay as agreed:

  • Late fees
  • Damage to your credit report and score (30 days late or more)
  • Calls for the lender's collection department
  • Your account sent to a collection agency
  • A lawsuit and judgment
  • Possible wage garnishment, bank account levies and/or liens against your home

The bottom line: Never borrow what you cannot comfortably repay.

Alternatives to Unsecured Personal Loans

It may be that an unsecured personal loan is not the right financial option for your situation. There are several alternatives to consider.

Credit cards

Available to just about anyone with a pulse, credit cards are convenient, easy to use, and just about universally accepted. If you pay off credit cards each month, they are extremely useful. However, if you allow balances to linger, you will pay. According to the Federal Reserve, the average credit card interest rate as of this writing was 16.88%.

Personal lines of credit

A personal line of credit is a preapproved loan that you don't have to take unless you need it.Similar to credit cards, personal lines of credit are spending limits granted by lenders. If you accept a line of credit, you have the right to access cash at a future date. This might be a check, transfer to your checking account, or a card. Unlike fixed personal loans, personal lines of credit generally come with variable interest rates. But the beauty is that you only pay interest if you end up using the money. This makes them ideal for emergency funding.

Overdraft protection

One of the best financial products for consumers is checking account overdraft protection. This is a line of credit that only kicks into to action if you write checks which exceed your checking account balance. Instead of an overdraft - and overdraft fees - overdraft protection simply pays the check. You pay back the overdraft advance as quickly as possible - with interest. It's convenient, but can be very expensive.

Unsecured Loans to Avoid

Borrowing is something to do with caution and in some cases it is something not to be done at all. Payday loans and check advance loans are each forms of financing to avoid.

"The ads are on the radio, television, the Internet, even in the mail," explains the Federal Trade Commission (FTC). "They refer to payday loans, cash advance loans, check advance loans, post-dated check loans, or deferred deposit loans. The Federal Trade Commission, the nation's consumer protection agency, says that regardless of their name, these small, short-term, high-rate loans by check cashers, finance companies and others all come at a very high price."

How Do Payday Loans Work?

Payday loans are very short-term advances with very high fees. You might borrow $100 for 14 days, and to do it, you write the lender a check for $115. That's 15% for two weeks. But what's worse is that most borrowers roll over their loans repeatedly and pay another fee every time. According to the Center for Responsible Lending, the average borrower rolls over the loan repeatedly (one 1% of borrowers take a single payday loan) and pays interest at a rate of 400% a year.

Yikes - stay away.

What Are Secured Personal Loans?

Unsecured personal loans can be a very good deal if you have a strong credit score and a well-documented credit report. But what if you've run into a tough financial patch? Lenders might want too much interest, or their loan terms may not be attractive.

What to do? Consider a secured personal loan. A secured personal loan - just like a mortgage - is back by collateral. "Collateral" an asset the lender can take if you don't repay the loan.

Secured Personal Loan Interest Rates

Because an asset with a known value is involved, secured loans at this writing have interest rates a touch below 10% for individuals with credit scores around 600. Like unsecured personal loans, your interest rate depends on your credit score (but to a lesser extent), your debt-to-income ratio (your income and debt picture determine your ability to repay the loan), and the value and liquidity of the collateral. It's much easier and less expensive to borrow against property than a baseball card collection.

Where to Find Secured Personal Loans?

Secured personal loans are sold by mainstream lenders like banks, credit unions and online lenders. Some lenders specialize in financing based on the type of collateral. For instance, there some lenders will only lend against fine art, or jewelry or collectible automobiles.

What Happens if You Don't Repay Secured Personal Loans?

It depends on the loan, the collateral and the lender. If you had to put your coin collection in the lender's vault, you won't see it again unless you repay your loan. If you pledge property, you may go through foreclosure. If you pledge a car, you may find an empty parking spot when you get off work.

If there's a good chance that you can't repay a secured personal loan, you're probably better off just selling the asset in the first place.

Secured Loans to Avoid

Secured personal loans have two sides. They can be seen as useful for borrowers with limited choices. However, if unpaid, they can produce outsize negative consequences. In the case of secured personal loans the odds of default are significant because of poor credit quality. The results which follow can be especially damaging, especially in the case of auto title loans.

Auto title loans

Having a personal loan secured by a car is an option to avoid for two reasons, cost and the potential for personal disruption.

Auto title loan lenders, says the Federal Trade Commission, "often charge an average of 25 percent per month to finance the loan. That translates to an APR of at least 300 percent. It could be higher, depending on additional fees that the lenders may require. For example, if you borrow $500 for 30 days, you could have to pay, on average, $125 plus the original $500 loan amount - $625 plus additional fees - within 30 days of taking out the loan."

Just on the basis of costs auto title loans should be avoided. But just as bad, and perhaps worse, is that auto title loans often make use of disruptive technology to enforce loan terms.

"As auto lenders reach out to those with poor credit," reported The New York Times in 2014, "they are increasingly using starter interruption devices, technology that allows them to remotely disable a car, to spur timely payment."

Think about what this means. A borrower with bad credit fails to pay an auto title loan for a few days. The lender disables the car. It doesn't move. How does the borrower get to work to earn the money needed to repay the debt?

Alternatives to Secured Personal Loans

When considering a secured vs unsecured loan, there are only two reasons to choose a secured loan - because it's cheaper or because you don't qualify for unsecured financing. If you don't qualify for a secured or unsecured personal loan, it's time to start putting a few dollars aside each week until you have an emergency fund. Just $400 will probably keep you out of the clutches of payday and auto title lenders.

You can start this fund by selling off things you don't need - eBay, garage sale, whatever. Take on a few extra hours at work, pick up a side gig. Get rid of monthly app and entertainment charges until you have this money set aside. A temporary belt-tightening can start you on a better financial path.

Once you have your emergency fund, consider pledging some or all of it to get a secured credit card. Secured credit cards are not really credit, because the lender can take your money if you don't repay. But they can help improve your credit rating, establish better habits, and eventually, the lender may increase your credit line or release your money.

How to Shop for a Secured Personal Loan

Secured personal loans are less common than unsecured personal loans. But the shopping process is the same. Contact several competing lenders - online, by phone or in person - and provide them all with the same information. That means the desired loan amount and term, an estimate of your credit score, your debts and income, the nature of your collateral and its value. Look over the offers you receive and choose the best rate and cost structure.

How to Apply for a Secured Personal Loan?

Applying for a secured personal loan is not that different from applying for an unsecured personal loan. You'll complete an application - in person, by phone or online - the lender checks your credit, verifies your debts and income. The only difference is the collateral. You'll have to prove its value and that you own it. Requirements vary depending on what you're offering as security.

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