Consolidating high-interest rate credit cards, funding home renovation projects, paying for large expenses like a move or a wedding — these are just a few reasons why people might need a little financial help from a personal loan. But, not all loans are the same — there are multiple loan products and lenders to choose from.
Before you jump into applying for a loan, you may want to understand the differences between secured and unsecured loans — and what it means to use collateral on a personal loan.
What is Collateral?
Collateral is something of value that you own—like a car or a piece of property—that you offer to a lender as a form of compensation in the event you’re unable to repay the loan. This makes lending money to high-risk consumers a safer option for lenders since they can claim your asset if you default on your loan.
What Types of Loans Require Collateral
Certain factors like your credit score, debt-to-income ratio, payment history, and monthly income are taken into consideration when a lender is deciding whether to approve you for a personal loan. If the lender believes you’ll have trouble repaying what you borrow, they may suggest you take out a secured loan. Unlike unsecured loans, secured loans require something of value to back the loan to serve as a form of repayment should you default on your payments.
Types of Collateral that are Commonly Used to Secure a Personal Loan
A lender may consider the equity you have in your home as collateral to back a secured loan. This may be a risky move, considering the lender could seize your property if you don’t repay the loan. Another thing to consider is the amount of time it will take to get a secured loan with home equity used as collateral — lenders will likely have to verify your asset which could require gathering paperwork from your mortgage.
Investment and Bank Accounts
In some cases, you might be able to borrow money by using your investments like savings, certificates of deposits and other investment accounts as collateral. Be mindful, however, that securing a personal loan with this type of collateral means you’re offering up the money you have readily available to you if you can’t make your payments.
Some secured personal loan and auto title lenders may require you to put up your car, truck or other forms of transportation to back a secured personal loan. This may be a better option than other types of collateral or a payday loan, but if you can’t make payments you run the risk of losing your vehicle.
A payday loan could be secured by your employment income or paychecks — another risky move that could subject you to wage garnishments if you can’t repay what you borrow.
When is a Secured Loan with Collateral a Better Option than an Unsecured Loan?
A secured loan may be a better option than an unsecured loan if you have a low credit score. Since the collateral you use to back the loan protects the lender, a secured personal loan may offer lower interest rates and a higher loan amount. But, keep in mind, you need to be 100% certain that you can afford the loan. If you miss payments, you run the risk of handing over an important asset to the lender.
Some secured loans are also riskier than others. Make sure you do some research, know your credit score and shop around before you commit to borrowing money with collateral. Also, take into consideration how close you might be to qualifying for an unsecured loan. Are there steps you can take to improve your credit score, so you don’t have to put your home, vehicle, savings or income at risk?
The Downside of Borrowing with a Secured Loan
The biggest downside of borrowing with a secured loan is that you could lose whatever you submit as collateral if you don’t make payments on time. And sometimes this means giving up an asset that’s important to you, like your home or automobile. Be sure to carefully weigh your options and look at your budget before you make a risky financial decision.
Secured vs. Unsecured Loans: Which One is Right For You?
Knowing which type of loan is right for you depends on several things including, how much you need to borrow, the purpose of your loan, your ability to pay it back and your credit score.
Generally speaking, a credit score of at least 640 could qualify you for an unsecured loan which may be the right financial solution for you if you need fast and easy access to funds. With an unsecured loan, you’ll have peace of mind knowing that you don’t have to put your home, savings or car at risk.
If your credit score is lower than 640, you may be in the market for a secured loan. A secured loan may offer higher loan amounts and lower interest rates, but as we’ve mentioned, you’ll be putting something of value in jeopardy if you can’t pay it back.
It’s a good idea to check your credit report and score before you commit to borrowing more money — knowing where you may stand in the eyes of a potential lender could help you make smart borrowing decisions.
This article is for educational purposes only and is not intended to provide financial, tax or legal advice. You should consult a professional for specific advice. Best Egg is not responsible for the information contained in third-party sites cited or hyperlinked in this article. Best Egg is not responsible for, and does not provide or endorse third party products, services or other third-party content.