Unsecured loans don't need any collateral
If a loan is unsecured, it means you don’t need to put anything up as collateral. Collateral is when you put down money or an asset (eg. a car or home) to act as a guarantee for a loan. If you fail to repay the loan, this will be used to pay back your debt. Most standard credit cards and small personal loans are unsecured.
To be accepted for an unsecured loan, lenders will look at your credit report and other personal information to assess your level of risk, and decide whether to lend to you based on this information.
Secured loans, on the other hand, are secured by collateral
When a loan is secured, it’s connected to something valuable you own. This collateral acts as a guarantee that you’ll pay your debt. If you’re unable to repay your loan for any reason, the lender will have the right to sell this asset to pay back the debt you owe.
Home loans (mortgages) are the most common type of secured loan. Here, it’s your home that acts as collateral; your lender can take it from you if you default on your mortgage repayments.
However, other types of loan (such as large personal loans) can also be secured. The collateral is usually your home or something else of value, such as a savings account, your car or even jewellery. So in theory you might have your original mortgage and another loan secured against your house – this is sometimes known as a ‘second mortgage’.
Home equity loans
Secured loans where your home acts as collateral may also be known as homeowner loans, home equity loans or ‘second mortgages’. The amount you can borrow will depend, in part, on how much equity you have in your home.
You can find out how much equity you have in your home by subtracting the amount outstanding on your mortgage, from your home’s current market value.
Example: Your home is currently valued at $500,000, which means it should sell for at least this amount if you put it on the market today. You still have $150,000 left to repay on your mortgage. This would mean your equity is $500,000 minus $150,000. So your equity is $350,000.
What are the advantages of secured loans?
Secured loans are less risky for the lender. In the worst case scenario, your lender can use your collateral to recoup any outstanding debt that you’re unable to pay. For this reason, secured loans typically:
- Are easier to qualify for
- Attract lower interest rates
- Allow you to spread your repayments over a longer period of time, giving you greater flexibility
- Make it possible for you to borrow larger amounts.
Lenders will look at your financial history, your income and your regular expenses when deciding whether to approve your loan application. However, since there’s less risk involved, they tend to be more sympathetic to those with a lower credit score when a loan is secured.
What are the downsides of secured loans?
The most obvious disadvantage is that you risk losing something potentially very valuable to you, like your home. That's why it's particularly important to plan ahead to help make sure you'll be able to afford the repayments.
- Secured loans are riskier for the borrower. If you’re unable to pay back your debt for whatever reason, you may lose what you’ve put up as collateral.
- There are additional formalities involved, so it can take longer to set up the loan. For instance, your lender may want to have your collateral independently valued in order to make sure it’s worth enough to cover the amount you want to borrow.
- Additional formalities also mean increased loan setup costs. You’ll usually be the one responsible for paying these additional fees and charges.
- Defaulting on a secured loan will still damage your credit score, even though your collateral is used to settle the debt. You may also get charged a late repayment fee.
And what downsides do unsecured loans have?
- They’re riskier for your lender, so interest rates are usually higher.
- The repayment period is usually shorter, so your monthly repayment will be higher than it would be on a secured loan.
- You won’t normally be able to borrow large amounts.
- Your personal financial circumstances (income, expenses and outstanding debts) and your credit history are an important factor in your lender’s decision.
So which one should you choose?
If you want to borrow a small amount of money over a relatively short amount of time, unsecured loans are usually the better choice.
They’re less risky for you, because your property (or anything you’ve put up as collateral) isn’t automatically seized if you default. And, while interest rates tend to be higher than those on secured loans, this is usually balanced out by a shorter repayment period and lower setup fees.
The flipside is that, since the borrower is taking on the majority of the risk, your credit history plays a more important part than it usually does on a secured loan. Your lender is trusting you to repay your debt in full and on time. So, they’ll want to see a history of responsible borrowing.
The best interest rates and terms on unsecured loans are usually reserved for those with the best credit scores. If you have a less than stellar credit report, you may get less favourable terms or be rejected altogether.
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Bear in mind that with an unsecured loan, you’re usually only able to borrow up to $50,000 for a maximum of around 5 years (depending on the lender). If you’re borrowing to finance a larger expense, maybe a new home or a major renovation, then you might need a secured loan.
Helpful hint: A loan isn’t the only way to get credit. If you want to borrow very small amounts on a regular basis - or simply aren’t sure exactly how much you need - a credit card might be a better option. Depending on your needs, for example, a 0% credit card might make using your credit card cheaper and more flexible than taking out a loan.