To be a smart borrower, you need to understand the differences between types of loans. Two of the most common loan types are the secured loan and the unsecured loan. Here's what you need to know about each.
Understanding secured loans
When you take out a secured loan, you have to use something of value that you own, like your car, home, or other valuable personal property. This is called collateral. The lender holds the title or deed to the collateral or places a lien on the collateral until you pay the loan off in full. If you do not repay the loan, the lender has the right to take possession of the collateral and apply the proceeds of the sale of the collateral to the outstanding debt.
The borrowing limits for secured loans are usually higher than those for unsecured loans because of the presence of collateral. Mortgages and home equity lines of credit are two common types of secured loans. Secured loans can have either a fixed or variable interest rate and can last for a set or variable amount of time. Think of a 30-year mortgage compared to an open-ended home equity line.
You may have a longer time to pay back a secured loan, in comparison with unsecured loans, and interest rates are frequently lower because the lender holds your collateral and faces less risk if you don't pay back the loan. The process of getting approval for a secured loan may take longer and require more paperwork.
How is an unsecured loan different?
An unsecured loan is money that you borrow without having to use something of value that you own as collateral. Most unsecured loans have a fixed term and a fixed interest rate. This means:
- you have a set amount of time to repay the loan
- the loan payment is the same each month
- the interest rate cannot change during the term of you loan
The approval process for an unsecured loan is usually quicker than for a secured loan because there is less paperwork. There is usually a lower borrowing limit for this type of loan. Because you are not using anything of value, as with a secured loan, the lender faces a higher level of risk. Because of this, the interest rate for this kind of loan is often higher than for a secured loan.
Know before you borrow
Both secured and unsecured loans can differ a good deal from one lender to the next, so it's important that you have a clear understanding of how your loan will work, what you'll have to pay each month and over the life of the loan, what you're promising to the lender, and what the lender is promising you in return. Ask your lender to provide an explanation of all the details in plain English. Before you make any borrowing decision, make sure you can afford to pay back your loan in a timely matter without straining your budget.
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