Definition
A secured loan is a type of loan that is protected by an asset or collateral, such as a car or home. If the borrower defaults on the loan, the lender has the right to take possession of the collateral. On the other hand, an unsecured loan does not require collateral and is primarily based on the borrower’s creditworthiness.
Key Takeaways
- A Secured Loan is a type of loan that requires collateral from the borrower to protect the lender against the risk of default. If borrower defaults, the lender can seize the assets.
- An Unsecured Loan, on the other hand, does not require any collateral. The lender’s decision is mainly based on the borrower’s creditworthiness. If the borrower defaults, the lender can’t automatically take the borrower’s assets.
- The major difference between secured and unsecured loans is the risk involved. Secured loans are less risky for the lender but can be more risky for the borrower, while unsecured loans are riskier for the lender but less risky for the borrower.
Importance
The finance terms “secured” and “unsecured” loan are important because they describe the two main types of lending and reflect the level of risk assumed by both the lender and borrower.
A secured loan requires collateral from the borrower such as a car or home, which the lender can seize if the borrower fails to repay the loan.
This type of loan poses less risk to the lender and thus tends to come with lower interest rates.
On the other hand, an unsecured loan does not require collateral, making it a higher risk for the lender, who may charge higher interest rates as a result.
Understanding these terms and the distinctions between them can significantly impact a borrower’s financial planning and obligations, and the costs associated with borrowing.
Explanation
Secured and unsecured loans serve different purposes in individual finance management and have different impacts on personal credit and collateral requirements. A secured loan is primarily used for substantial purchases like vehicles, homes, or other high-value properties and is termed “secured” because it is backed by an asset or collateral. The collateral’s purpose serves as a guarantee for the lender that if the borrower fails to repay the loan, the lender can take possession of the collateral to cover the loss, reducing the lender’s financial risk.
On the other hand, an unsecured loan is not backed by collateral. Its primary purpose is to fund personal expenses like education, home improvement, or vacation, where a physical asset is not involved. The approval of an unsecured loan relies heavily on the borrower’s creditworthiness, rather than assets.
Thus, it’s often viewed as a higher risk to lenders. If the borrower defaults on the loan, instead of seizing an asset, the lender often has to take legal action to recover the amount. Despite the higher risk, unsecured loans are preferred by many due to the quick funding process and the absence of risk to personal property.
Examples of Secured vs Unsecured Loan
Mortgage Loans vs Credit Card Debts: A mortgage loan is a prime example of a secured loan where the bank or lending institution provides you with a huge sum to purchase property and this property serves as collateral for the loan. If you default on the loan repayments, the lender can take possession of the property. On the other hand, credit card debts are usually unsecured loans as they do not require any collateral. If a person fails to repay the credit card debt, the card company can’t directly seize any of the debtor’s assets. However, they can take legal action to recover the money.
Car Loans vs Personal Loans: A car loan is a secured loan where the purchased vehicle is used as collateral. If the borrower fails to make the repayments, the lender can repossess the vehicle. A personal loan, however, is usually an unsecured loan provided based on the borrower’s creditworthiness and does not require any collateral. Therefore, if the borrower defaults on a personal loan, the lender’s only recourse would be legal action.
Home Equity Loans vs Student Loans: A home equity loan is another example of a secured loan where the borrower uses the equity of his/her already existing property as collateral. If the borrower fails to repay, the lender can claim the house or sell it to recover the loan amount. Conversely, student loans are typically unsecured loans which are granted based on one’s financial need or academic qualifications, not backed by any physical asset, so the lender cannot directly seize assets if payments aren’t made.
FAQ: Secured vs Unsecured Loan
What is a Secured Loan?
A secured loan is a type of loan in which the borrower pledges an asset (e.g. a car or a house) as collateral for the loan, which then becomes a secured debt owed to the creditor who issued the loan.
What is an Unsecured Loan?
Unsecured loan is a type of loan that doesn’t require any collateral. The eligibility of the borrower is usually based on their credit score and income. Credit card debts, personal loans, and student loans are examples of unsecured loans.
What is the main difference between Secured and Unsecured Loans?
The main difference between the two is that secured loans require collateral, whereas unsecured loans do not. Because of this, secured loans often have lower interest rates, as the risk to the loaner is reduced.
What happens if I default on a Secured Loan?
If you default on a secured loan, the lender has the right to seize your collateral to cover the loss. This may also negatively affect your credit score.
What happens if I default on an Unsecured Loan?
If you default on an unsecured loan, lenders can use a collection agency to collect the debt or can sue to get their money back. Defaulting can seriously harm your credit score and can lead to wage garnishment.
Related Entrepreneurship Terms
- Collateral
- Credit Score
- Interest Rate
- Default
- Repayment Schedule
Sources for More Information
- The Investopedia: https://www.investopedia.com
- Bankrate: https://www.bankrate.com
- NerdWallet: https://www.nerdwallet.com
- The Balance: https://www.thebalance.com
