Individuals in the market for a loan may find themselves overwhelmed with the number of choices, the most basic of which is often whether the loan should be secured or unsecured. Each type of loan has its own distinct advantages and disadvantages, and borrowers should weigh each aspect carefully before taking on either version of debt.
In their most basic definitions, secured loans and unsecured loans differ based on the use of collateral. When a borrower applies for an unsecured loan, he is requesting a loan based on his own promise to repay the funds along with interest. When a borrower requests a secured loan, however, he offers some item of value to “secure” the loan, giving the lender partial ownership in the item as a guarantee that the funds and interest will be repaid on time.
Because secured loans give the lender some assurance that the loan and interest will be paid, along with legal material recourse if payments are missed, secured loans may be somewhat more attainable than their unsecured counterparts. Car dealers that advertise attainable financing generally use secured loans; if the borrower fails to repay the loan, the dealer simply repossesses the car and resells it to recoup its financial losses. By using secured loans, a borrower who would otherwise be unable to obtain a loan on her own credit can still obtain financing for a major purchase.
When lenders issue a loan, the interest rate charged to the borrower reflects a number of factors. One of these factors is the risk assumed by the lender; if the borrower fails to repay the loan, the interest must be sufficient to help offset some of the institution’s losses. When a borrower uses collateral to secure a loan, the risk to the bank, or lender, is considerably reduced; in return, many financial institutions offer a lower interest rate on secured loans. Borrowers with a troubled credit history may still be subject to a high interest rate, though, as interest on some car loans can soar into the double digits.
While the risk to the lender is significantly reduced when a borrower secures a loan, the risk is offset to the borrower. If a debtor is unable to make regular payments for some reason, the lender may repossess (or, in the case of a home loan, foreclose on) the collateral used to secure the loan. In the event of a repossession or foreclosure, a borrower stands to lose not only the funds already paid toward the debt, but the entire value of the collateral, as well. If the lender is unable to cover the remaining balance of the loan by reselling the collateral, the borrower may also be responsible for any outstanding debt even after losing the item used to secure the loan.
When a borrower asks for a loan based solely on his promise to repay, many banks will fund only small amounts in order to minimize their financial risk. For this reason, unsecured loans for large amounts—over $50,000, for example—are somewhat uncommon. For large loans, like those used to purchase houses or commercial properties, borrowers should expect to offer some collateral, usually the property being financed.