How do secured loans work?
Key takeaways
A secured loan requires you to pledge collateral — something of value like a savings account or car.
If you default, a lender can seize the collateral to satisfy the debt.
Secured loans often have higher loan amounts and lower rates than unsecured loans.
Loans are a way to finance a variety of costs, and they come in two forms — secured and unsecured. In short, secured loans require collateral while unsecured loans do not.
You’ll also find that secured loans are typically easier to qualify for and have lower interest rates as they pose less risk to the lender. Still, they may not be the best option for you and could have serious consequences for your credit and finances if you cannot repay what you borrow.
What a secured loan is and how it works
Secured loans are debt products that are protected by collateral. This means that when you apply for a secured loan, the lender will need to know which of your assets you plan to use to back the loan.
The lender will place a lien on that asset until the loan is repaid in full. If you default on the loan, the lender can claim the collateral and sell it to recoup the loss. It is important to know precisely what you are promising and what you stand to lose before you take out a secured loan.
Pros and cons of secured loans
Secured loans offer many advantages, like typically large borrowing limits, but they also have some risks.
Pros
Larger borrowing limits. Secured loans often have higher maximum loan amounts than unsecured loans.
Lower average rates. Lenders typically offer lower rates for secured loans than unsecured ones.
Cons
Risk of losing collateral. A lender can seize the collateral used to secure the loan if you default.
Potential lack of flexibility. Some secured loans can only be used for its intended purpose.
Secured loan vs. unsecured loan
Some loans, such as personal loans, can be either unsecured or secured, depending on the lender. If you don’t qualify for the unsecured option or you’re looking for the lowest possible interest rate, check if the lender offers a secured loan option.
When choosing a secured versus an unsecured loan, there are multiple factors to consider. Here are a few key differences between the two.
Secured loan | Unsecured loan | |
|---|---|---|
Availability | Must have an asset to use as collateral | Collateral not required |
Borrowing limits | Higher borrowing limits if you’re putting up collateral of equal or greater value | Lower borrowing limits that may not be sufficient for your funding needs |
Credit score | Credit score and financial health will determine eligibility, but they could be more accessible if you have bad credit | Credit score and financial health will determine eligibility, and you generally need good or excellent credit to qualify for the most competitive loan terms |
Eligibility criteria | Less stringent since the lender assumes lower risk | More stringent since the lender has no rights to the collateral if you default on the loan |
Interest rates | Typically lower | Typically higher |
Penalties | Collateral can be seized, credit score will drop | Missed payments will enter into collections, credit score will drop |
Loan types | Mortgages, HELOCs, auto loans, business and secured credit cards, etc. | Unsecured credit cards, student loans, personal loans, etc. |
Types of secured loans
There are many types of secured loans. Five of the most common include:
Mortgage: With a mortgage, you put your home or property up as collateral to buy that home. If you fail to make the payments, your home can be foreclosed on.
Home equity line of credit: A home equity line of credit (HELOC) gives you access to your home equity in the form of a credit line, which is somewhat similar to a credit card. With a HELOC, you also put your home up as collateral.
Auto loans: When taking out a loan to pay for a car or any other vehicle, your vehicle will often be used as collateral. If you don’t make the payments on time and in full, your vehicle could be seized.
Loan for land: A land loan is used to finance the purchase of land. This type of loan uses the land itself as collateral.
Business loan: A secured business loan can be used to buy equipment, pay wages or invest in business projects. There are a number of things you can use as collateral, including inventory, equipment or your land or building.
Types of collateral used
What you use as collateral likely will depend on whether your loan is for personal or business use. Some examples of collateral include:
Real estate, including equity in your home.
Cash accounts (retirement accounts typically do not qualify).
Cars or other vehicles.
Machinery and equipment.
Investments.
Insurance policies.
Valuables and collectibles.
Secured loans and default
After a few missed payments on a secured loan, the lender will likely repossess the asset used to secure the loan. And repossession is not the end of the matter. If the repossessed asset does not sell for enough to cover the amount of your loan, you are responsible for the difference.
For example, if you owe $20,000 when you stop making payments on a boat loan and the boat is repossessed and sold for $15,000, you will owe the lender the outstanding $5,000 and any outstanding fees. The default stays on your credit report for seven years from the first payment you missed.
If you miss payments on a mortgage, home equity loan or business loan, the lender has a lengthier process to recoup its money. In about half the U.S. states, a lender must go to court to foreclose on a property. In the other half, the lender must provide you with advance notice of foreclosure.
What to do if you can’t repay a secured loan
If you’re having difficulty repaying a secured loan, there are a few steps you can take.
Contact the lender. Contact your lender to discuss your options. The lender may agree to modify your loan terms, including a new payment schedule, new repayment term or temporarily pause payments via loan deferment.
Seek financial help. You can reach out to a consumer credit counseling agency certified by the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Association of America (FCAA). Also, consider speaking with the U.S. Department of Housing and Urban Development-approved housing counselor to help you negotiate loan modification terms with your mortgage provider.
Prioritize your bills. Focus on paying the ones that have the most serious consequences for nonpayment. For example, making your home loan payment may take priority over paying your credit card bill.
