If you need to borrow money, a fundamental choice you have is between a secured loan and a non-secured loan. It is important that you understand what difference that choice would make in your situation, because it could affect both the cost of your loan and the extent to which you are putting valuable property at risk.
There is no easy answer to this question. It's not like secured loans are fundamentally good or bad - their merit depends a great deal on the situation. The more you understand the pros and cons of secured loans, the better you can decide whether one is a good fit for you.
What is a Secured Loan?
A secured loan is a loan backed by collateral, which is property of sufficient enough value to cover the principal of the loan should the borrower fail to repay.
However, the collateral does not always have to be the property the loan is being used to purchase. You may already have property you can use as security for a loan - often, this is property like a long-term investment portfolio or an art collection that you don't want to liquidate to simply make a purchase in cash. Instead, you would like to keep that property intact but use its value to borrow against for your new purchase.
From the lender's point of view, having that property as collateral makes them more confident in lending money. As a result, they should be more likely to make the loan, and to offer more favorable terms.
What Can You Use to Secure a Loan?
In theory, any property of value can be used to secure a loan. In practice though, lenders are looking for property whose value is easy to establish and which can be readily seized if you default on the loan.
Mortgages are secured loans. This is not only true when you use one to buy a home, but also when you borrow against the equity in your home with a cash-out refinance loan, a home equity loan, or a home equity line of credit. If you have equity in your home and you are confident in your ability to repay a new loan against that equity, then borrowing against your home has a couple of clear advantages over other secured loans. It is likely to represent the largest amount of potential security you can offer and thus allow for higher loan amounts. Also, securing your loan with home equity is likely to result in a much lower interest rate than other forms of secured loans.
If you don't have equity in your home, cars are a fairly common form of loan security. This depends on your having built up some equity in your car, meaning that the car is worth substantially more than you already owe on it. You may be able to borrow against that equity through a new loan or by refinancing your existing loan.
If you use a car to secure a loan, just be sure to distinguish between auto title loans and auto equity loans. Auto title loans require little in the way of a credit check but they generally carry exorbitant interest rates and severely limit the amount of your car's value you can borrow against. Auto equity loans with stricter qualification standards are likely to carry a lower interest rate if you qualify, but even then these are an expensive way to borrow money and should only be used for short-term emergencies.
Another fairly common form of security for a loan is a bank account, such as a savings account or a certificate of deposit (CD). Generally speaking though, it does not make sense to borrow against a bank account rather than just use cash from that account, because you will probably pay much higher interest on the loan than you will be earning in the account. However, if you have a long-term CD at a decent interest rate, it may make sense to borrow against the CD rather than cash it in if this allows you to avoid an early withdrawal penalty, especially if the loan is for a very short time.
Other property, such as boats, art collections, etc., may also be used to secure a loan. However, this is possible only if the property has substantial, verifiable value, and much less common forms of security are likely to significantly restrict which lenders will work with you.
Where Can You Get Secured Loans?
There are three major types of lenders you can go to for secured loans:
- Bank lenders. If you already have a relationship with a bank, this might be a good place to start, but be advised that not all banks offer secured loans and your current bank may not necessarily offer the most competitive terms on secured loans.
- Credit unions. Some credit unions offer many of the same services as banks, including loans. This would require that you be a member of the credit union, but membership requirements have become much less restrictive over the years.
- Non-bank lenders. There are many firms that specialize in lending without offering traditional bank services, like deposit accounts. Many of these non-bank lenders have a strong on-line presence, which makes finding and comparing rates all the easier.
Use these choices to your advantage by shopping around for the best loan terms available. Because interest rates on secured loans can be fairly steep, shopping around can result in significant savings.
Risks to Consider About Secured Loans
Putting up property can help you get a loan, but this is not a decision to be taken lightly. Here are three things to consider first:
- Having property does not mean you can afford the loan. The issue here is having enough cash flow to make the loan payments. You may have some personal property worth $10,000 which can help you get a $10,000 loan, but the real question is whether your income and existing expenses will allow you to make the payments on the loan. If not, you risk forfeiting that property or having to liquidate it under unfavorable circumstances.
- Job security is a key variable. Looking at your current budget to see if you can afford the loan payments is important, but it is only a start. Loans are typically multi-year commitments, so you need to be confident that your income will continue to be enough to support the loan payments. This involves assessing your job standing at your current employer, the stability of that employer, and the marketability of your job skills should you have to make a change.
- The risk of losing your property is serious. If there is a reason you don't want to simply sell your property and use the cash now, chances are you won't want to be forced to sell that property later on to make good on the loan. That may entail losing property that is hard to replace, or having to liquidate an investment portfolio at an inopportune time. The lender may consider seizing the collateral as an acceptable fallback position should you default on the loan, but you should not view it as an acceptable outcome.
Why Secured Loans Can Work for You
The risks outlined above are serious considerations, but they do not mean secured loans cannot work out well for you. Here are three reasons it might be the right choice:
- It may be less expensive than an unsecured loan. Lenders use interest rates in part to compensate for risk. If you reduce the riskiness of the loan by securing it with collateral, chances are they will reduce the interest rate.
- It could help you build or rebuild your credit history. If you don't have much credit history or, worse, if that history is damaged, you may have trouble getting a loan without collateral. A secured loan might be a good start in building a favorable repayment history - if you make sure you keep up with those payments.
- Non-payment has pretty serious consequences anyway. Whether a loan is secured or unsecured, you should think through your ability to repay very carefully before you commit to the loan, because non-payment has serious consequences beyond just the seizure of collateral. Your credit rating is certain to take a hit, other forms of credit are likely to become more expensive or unavailable in the future, and you may face costly legal action. Just because a loan is unsecured does not mean there are not risks to defaulting.
What this comes down to is borrowing only when you have a good purpose for the money and have thoroughly examined your ability to repay. Those principles should apply to any loan, but the stakes are even higher with a secured loan.
Whether you choose a secured or unsecured loan, remember that different lenders are likely to offer different interest rate and fee terms for loans that otherwise seem identical. Some shopping around can make your loan decision as cost-effective as possible.