Secured versus unsecured loan: If you’re Googling this phrase, odds are you’re immersed in the process of looking for a loan, and need some clarification on the difference between these two types. So here’s the deal: A secured loan means you put up something of value as a promise you’ll pay the loan back. An unsecured loan requires no such collateral. Now let’s dive into the details.
When to get an unsecured loan
An unsecured loan, also known as a personal loan, is enforced by a contract signed by the borrower and the lender of the unsecured funds. Loans such as credit cards, lines of credit, and student loans are common types of unsecured loans.
Why you need a secured loan to buy a home
While unsecured loans are typically the way people make smaller purchases, for larger items like a car, boat, or home, you’ll need a secured loan. For real estate in particular, you’ll get a mortgage—the most common kind of secured loan there is.
“Mortgage loans are always secured by real property. That is the collateral,” says Andrew Weinberg, a principal at Silver Fin Capital. But there are other kinds of secured loans, too. A car loan uses your vehicle as collateral, for example.
Basically, if you want to buy a home but lack the cash to cover this massive purchase in full, you will apply for a mortgage by approaching a lender who will loan you most of the money to cover this purchase. Then, you pay the lender back in monthly installments, plus interest.
The clincher is if you don’t pay up, eventually your lender has the right to foreclose and take your property to recoup its expenses, says Manjari Ganti, associate compliance counsel at Planet Home Lending. That’s the “secured” part, and the reason why your lender was willing to fork over such a big pile of cash. The lender knows that even in the worst-case scenario in which you flake, it’ll get something valuable back!
Secured vs. unsecured loans: Which is better?
It depends on what you’re using the loan for. If you’re buying a home, a mortgage is definitely the way to go.
“Secured loans are safer loans for the lender, so they’re less expensive for the customer,” says Craig Garcia, president of Capital Partners Mortgage. “They will usually have better interest rates, and most mortgage interest is tax-deductible.”
Still, there are some instances when an unsecured loan makes sense for certain purchases. For one, unsecured loans are faster to get.
“If the need for money is immediate, it’s quicker and easier to get an unsecured loan,” says Garcia. “A secured loan has to be underwritten and have a closing, whereas you can walk into a bank or apply online and get a line of credit right away.”
Here are some of the pros and cons of these two types of loans:
- Mortgage interest is tax-deductible.
- Interest rates are usually lower, repayment terms are usually longer.
- It takes longer to get, and requires more paperwork.
- If you default on the loan, you could lose your house or car.
- It’s possible to qualify for much bigger loans than unsecured loans.
- For home buyers, programs such as FHA loans help buyers with checkered credit histories to qualify.
- Rates are higher, and repayment terms are usually shorter.
- You’re relying on your creditworthiness to get the loan, so not everyone can qualify.
- Interest is not tax-deductible.
- It’s faster to apply for and get.
- There are no restrictions on how you use the funds.
- If you can’t pay back the loan, there’s no immediate collateral to repossess or foreclose on.
- Loan amounts are smaller.
- With unsecured lines of credit like a credit card, the loan can be used and paid off on an ongoing basis.
Both secured and unsecured loans have their moments in life when they’re useful. To decide which is better for a particular need, review the terms, rates, and repayment schedule, and see what works best for you.
Before you take out any kind of loan, however, make sure you completely understand what you’re agreeing to, and be careful not to borrow more than you can realistically afford to pay back. Unpaid loans can wreak havoc on your credit score and mess up your financial life for a long time. But you already knew that, right?
Joe Barbee – ABR,MRP
Barbee Dream Homes Real Estate Group