In the simplest terms, a secured loan is a type of loan that is given to the borrower in exchange for collateral. As a borrower, it is incumbent upon you to provide an item of value as collateral for your loan. Should you fail to repay the loan under the terms agreed upon with the lender, you would be required to surrender that collateral item to the lender.
In other words, secured loans come with a certain amount of inherent risk to the borrower. On the other hand, some of the most common loan types are secured loans. For instance, mortgage loans and auto loans are secured loans. In this case, the item you collateralize is also the item that you are borrowing to pay for.
But there are other instances in which your secured personal loans actually require collateral that you already own such as real estate property, investment accounts, vehicles, and personal valuables such as coins, jewelry, and collectibles. In this case, you are taking on a considerable risk as the borrower.
Defaulting on your obligations will ultimately result in the loss of any such items. So why would it be worth the risk to apply for and accept a secured loan? Why might you actually want to enter into such a loan agreement?
We’ll explore the reasons that you might apply for a personal secured loan, and we’ll take a closer look at the risks that might come with this loan. But first, let’s take a closer look at exactly what unsecured loans are, particularly as they compare to unsecured loans.
If you’re considering a secured loan because your application for an unsecured personal loan has been rejected, we also invite you to check out our 10 tips for what to do if you’ve been rejected for a personal loan.
Otherwise, read on.
How Does a Secured Loan Work?
A secured loan works on the basis of collateral. Experian explains that collateral can include “physical assets like your house or car, or financial assets such as stocks and bonds. Secured loans are commonly used for large purchases. For example, if you use a mortgage to buy a home or an auto loan to buy a car, the loan is secured by the asset you purchased with it.”
This differs from an unsecured loan, where your loan is granted on the basis of your credit history and credit score. In other words, with an unsecured loan, a lender will use information in your financial profile to determine if you are worth the risk. If your credit score and payment history are good and you have a steady, provable monthly income, this will usually be sufficient to help you qualify for most unsecured personal loans.
However, in the case of secured loans, the size of the loan or the borrower’s payment history may incline the lender to reduce their own exposure to risk. With a secured loan, your collateral is ultimately what reduces the lender’s risk. In the event that a borrower defaults on a secured personal loan, the lender has the right to collect the collateralized asset as repayment.
In the simplest of terms, the borrower of a secured loan assumes the greater burden of risk for failure to repay the loan, whereas the lender assumes the greater burden of risk in the event of non-payment on unsecured loans. As Experian warns, “Because the financial and personal consequences of defaulting on a secured loan are serious, it’s imperative to understand what’s at stake before you apply for a secured loan.”
So what is at stake for the borrower of a secured loan?
Well, let’s say you place your home up for collateral so you can take out a secured personal loan in order to pay overwhelming medical bills.
If you have difficulty making your monthly payments, the lender can place a lien on your home. If you default on the loan at this point, the lender can repossess your home. In most cases, the lender will sell the repossessed asset in order to recoup the amount that you borrowed. When this occurs with a home, the repossession and sale is known as a foreclosure.
But that’s not all. Let’s say you buy the home during a time of robust economic growth, but you default in the midst of a sharp economic downturn. This would be an unfortunate but logical sequence of events. It could also mean that your home is worth less than it was at the time of your purchase. So when the lender attempts to recoup the value of its loan, the sum earned for the home’s resale may fall short of what you owe.
The lender could subsequently file a claim of deficiency against you for the remaining sum. This means you would lose your home as well as everything you’ve invested in your home, and you would still be in debt to your lender. Of course, all of this would represent a worst case scenario.
But, as you can see, the inherent risks of taking out a secured loan may be quite high, even if you’re looking at a traditional secured loan such as a mortgage.
With that said, there are several different types of secured loans–some more commonplace and less inherently risky than others.
Types of Secured Loans
Some secured loans are extremely commonplace financial arrangements utilized by model borrowers whereas others are largely reserved for less than optimal borrowers and may therefore carry magnified risk.
While the unsecured loan is the most common type of personal loan, the vast majority of America’s debts are tied up in mortgages. Mortgages are secured loans. As Forbes explains, “Mortgages are a common type of loan used to finance the purchase of a home or other real estate. These loans are secured by the financed property, meaning the lender can foreclose in the case of borrower default.”
Of course, this is an extremely familiar arrangement to most Americans. After all, says Ramsey Solutions, mortgage debt accounts for 70% of all American debt. The sum total of what we owe on our homes is well over $10 trillion! That debt is shared by more than 51 million households, or 42% of all American households.
So while mortgage loans constitute an extremely commonplace arrangement, it’s also important to acknowledge that this means some 51 million American homes are collateralized against debt to banks and lenders. While it goes without saying that most of these borrowers are qualified and credit worthy, this also hints at the somewhat tenuous nature of home ownership in the U.S. For many Americans, a sharp economic downturn or a run of personal economic misfortunes could trigger a series of events that lead to a loss of home ownership.
And again, foreclosure would also mean the loss of any equity invested into the property up until that point and possible continued action in the pursuit of money still owed to the lender. This once again underscores the inherent risk taken on by the borrower of a secured loan.
Home Equity Loans and HELOCS
A similar risk is implicated by the home equity loan or home equity line of credit (HELOC) loan.
With home equity loans or home equity line of credit loans, the borrower takes out a second mortgage on their home. This allows the borrower to receive a sum of money or a line of credit based on the value of their home. This may be an especially good option if your home has increased significantly in value since your initial mortgage signing. A favorable home equity loan could help to lower your interest rates and reduce the monthly payments on your mortgage.
That’s the good side. The downside is that defaulting on this loan can result in foreclosure on your home. In other words, this is only an option you should consider if you know that you can meet the conditions for repayment. Otherwise, you risk losing your most valuable asset.
Much as with mortgages, auto loans are collateralized by the asset you are borrowing to pay for. As Forbes explains, “Auto loans are secured by the vehicle being financed. To protect its interest in the collateral, a lender holds title to the financed vehicle until the loan is repaid in full.”
Auto loans have a few other factors in common with mortgages. Specifically, your eligibility to borrow money for this asset will be based in part on your creditworthiness. Additionally, failure to repay will result in loss of this asset. And finally, repossession will cause you to lose any equity that you’ve invested into that asset up until that point.
One more thing that auto loans have in common with mortgages–the arrangement is extremely commonplace. Indeed, with more than 100 million Americans sharing roughly $1.5 trillion in auto loan debt, according to a report from the Consumer Financial Protection Bureau, this sum total of our collateralized auto loan debt is exceeded only by our collective mortgage and student loan debts.
Secured Personal Loans
As noted from the start of this discussion, secured personal loans represent the riskiest proposition. Whereas the mortgage loan and auto loan outlined above use the asset that you are purchasing as collateral, secured personal loans are different. In this case, you are more than likely placing an asset that you already own up for collateral.
This could be anything from your home (or another piece of real estate) to a work of art with a high appraisal value; a vehicle to a valuable investment account; a set of rare collectibles to a unique family heirloom. As noted above, in the event that you, as the borrower, default on their loan, any collateralized items would be repossessed and sold by the lender as a way to recoup your unpaid debts.
But there are some unique benefits to secured loans, including lower interest rates and higher principal loan amounts. According to Nerdwallet, “These loans are offered by online lenders, banks and credit unions. Loan amounts are typically from $1,000 to $50,000 and may be tied to the value of your collateral. Annual percentage rates are from 6% to 36% and repayment terms are from one to seven years.”
Not only that, secured personal loans may be the only option for certain borrowers. Unsecured loans are given based on the borrower’s creditworthiness. If you have less than good to excellent credit, you may find it difficult to qualify for a traditional unsecured loan. Alternatively, you may also find that lenders who are willing to provide you with unsecured loans will impose exceedingly high interest rates on repayment as well as onerous origination fees.
If you are confident in your ability to make on time payments and fulfill your debt obligations in their totality, the secured personal loan may be your best option. In some cases, it may be your only option.
*A Note On Secured Credit Cards
Technically, secured credit cards fall into a slightly different area of discussion. But in the interest of preventing any confusion, it’s worth defining this type of secured loan as well. According to Nerdwallet , “Secured credit cards require a cash deposit that’s usually equal to the credit line. The card issuer holds the deposit in case you don’t pay your bill. These cards allow you to make credit card purchases and get payments reported to the credit bureaus.”
In other words, the collateral in this case is a sum of cash that you put up, which will be equivalent to your line of credit. Suffice it to say, this hardly carries the same level of risk as a secured personal loan or mortgage. In fact, secured credit cards are something of the opposite– offering a risk-free pathway to building credit for those whose borrowing power is largely stifled by their limited credit history.
Your secured credit card functions a little bit like a debit account. The major difference is that using your card and paying your bills on time can help create a good credit rating and ultimately pave the way toward greater borrowing power. This is often a great option for college students who are just getting started on building their credit.
Why Get a Secured Personal Loan?
So now that you know a bit more about the most common types of secured loans, let’s dig a little deeper on secured personal loans. The reasons to apply for a mortgage, home equity loan, or auto loan are pretty obvious. The core value of secured loans is that they allow lenders to mitigate their own risk in order to provide higher borrowing limits.
This makes it possible for borrowers to acquire costlier assets such as homes and vehicles. But what about the secured personal loan? This is the case that represents perhaps the greatest risk burden to the borrower. That’s because a secured personal loan must be collateralized by a valuable asset already in the borrower’s possession.
So what are the key reasons that you might consider taking on this risk?
Let’s start by assuming that, whatever your reasons for seeking a personal loan, the financial need is pressing. Whether you’re working to repay burdensome medical bills (like 21% of all personal loan recipients) or you’re looking to consolidate overwhelming credit card debts, there are various financially responsible reasons to pursue a personal loan.
But why would you need or want to take out a personal loan that is secured?
Well, there are a few compelling reasons:
You’ve Been Rejected For an Unsecured Loan
There are numerous reasons that you might be rejected for an unsecured loan. As noted earlier, unsecured loans are given based on factors like payment history and credit score. So you may have a robust income and a number of valuable assets while also failing to qualify for an unsecured personal loan based on negative credit marks from your past.
While this might make unsecured lenders wary of providing you with a loan, a lender providing unsecured loans can mitigate this risk by requiring you to collateralize some of the aforementioned valuable assets. While your personal risk is now higher, it may provide you with a pathway to a personal loan that you might not otherwise have been eligible to receive.
Your Unsecured Loan Options Carry High Interest Rates
Having fair or poor credit might not prevent you from receiving an unsecured loan altogether. But it would likely limit your options to just lenders offering high interest rates on repayment and high origination fees. The assumption is that, as a borrower with less than optimal credit, you may be willing to sustain these higher costs in order to receive a much needed loan.
With a secured loan, you may actually be able to receive much more favorable and manageable interest rates as well as lower fees and monthly payments. Again, you will be risking a valuable asset in order to attain those more favorable conditions. But this underscores why you might consider taking this risk.
You Have a Large Sum of Debt
As we’ve discussed, one of the basic precepts of secured lending is the idea that it reduces the lender’s exposure to risk. For this reason, lenders are typically willing to provide larger sums to borrowers. For those who are looking to consolidate and pay down debts from large purchases, credit card balances, and more, a secured loan may simply offer access to the largest principal loan amount.
Some Secured Loans Provide Tax Advantages
One other reason that you might consider a personal secured loan–there are some inherent tax benefits that come with this type of loan. According to Forbes, “Borrowers can take advantage of tax deductions for interest payments on some secured loans, such as mortgages.”
This is generally not the case with unsecured loans. Depending on the size of your personal loan interest rates, choosing to post collateral and apply for a secured loan could substantially lower your tax burden. Whether or not this is worth the risk for a personal loan will depend on your financial outlook, your creditworthiness, and the size of your debt.
What To Do If You’re Struggling to Repay a Secured Loan
We’ve placed a heavy emphasis on the risks that come with receiving secured loans. Even in the case of commonplace secured loans like auto loans and mortgages, it is absolutely critical that you understand what is at stake for you as the borrower.
We would also stress that if you have already received a secured loan of any kind and you are struggling to make payments on schedule, you should absolutely reach out to your lender to discuss your options. According to Forbes, “If you have a secured loan and think you may default, there are steps you can take to limit negative impacts on your credit score. Contact your lender immediately, review your budget and prioritize secured loan payments so you don’t lose your house or other valuable collateral.”
Some lenders may have a forbearance clause in the event of financial hardship. This could provide you with an avenue for pausing payments temporarily. While interest would likely continue to accrue, this forbearance could give you a few months of grace without the threat of a lien or foreclosure on your collateralized asset. There is no guarantee that your lender will offer this option, but you should absolutely reach out if you are facing difficulty making your payments.
Your lender may be able to help.
How to Get a Secured Loan
It’s easier than ever to get a secured loan from an online lender. Online lending makes it easy for lenders and borrowers to connect, create agreements based on collateral, and enter into legally binding arrangements.
As Nerdwallet explains, “Most online lenders that provide secured loans require a vehicle as collateral. Some let you apply for this loan upfront, but others may show you the option only after you’ve tried applying for an unsecured loan. Many lenders let you check your rate on an unsecured loan without affecting your credit, so you can pre-qualify with multiple lenders to find the best rate.”
Prequalification is a recommended step, largely because it provides a risk-free way of determining your likelihood of qualifying for a personal loan. While applying for a loan will result in a hard inquiry, which can lower your credit score by as many as five points and for up to 12 months, applying for prequalification will result in a soft inquiry, which will have no negative impact on your credit score.
This makes prequalification an excellent first step as you begin your search for the right unsecured loan for your needs.
If you are managing overwhelming credit card bills, you may actually want to consider a debt consolidation loan. Jump to our article on consolidation loans to find out if this is the right option for you.