What Is a Secured Loan?
A secured loan is a type of loan where the borrower pledges an asset as collateral to secure the loan. Collateral is an asset of value (e.g., car, house, valuables) that the lender can take if the borrower defaults on their loan payments. The collateral in a secured loan functions as a financial backstop for the lender, reducing the risk of loss.
Because secured loans are backed by some sort of collateral, they have lower interest rates and more favorable terms than unsecured loans, which do not require collateral.
Secured loans can be an excellent avenue for borrowers with a low credit score, lack of credit history, or tendency to miss interest payments to get the financing they need. However, secured loans may come at a higher risk because you are putting your collateral at risk.
Understanding how secured loans work can help you get the financing you need when you need it.
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5 Types of Secured Loans
Secured loans are issued every day. Here are five types of secured loans you should know to optimize your finances:
1. Mortgages
A mortgage is a secured loan specifically used to finance the purchase of real estate property, such as a primary home, condominium, or commercial building. In this type of transaction, the property you purchase is collateral for the loan.
Mortgages are long-term loans with fixed or adjustable interest rates. The most common types of mortgages include the 30-year fixed-rate mortgage, the 15-year fix-rate mortgage, and the adjustable-rate mortgage. Borrowers make regular monthly payments to repay the principal and interest over the life of the loan.
The mortgage market consists of many types of loans, including conventional mortgages, government-backed loans (FHA loans and VA loans), and adjustable-rate mortgages (ARMs). Each mortgage has its own eligibility criteria, interest rate terms, and repayment schedules. If you are a first-time homebuyer, you should carefully research and compare different mortgage structures and terms to find the best fit.
Related: 13 Tips on How to Save for a Down Payment While Renting
2. Auto Loans
Auto loans are secured loans used to finance the purchase of a vehicle, like a car, truck, or SUU. The vehicle itself serves as collateral for the loan. Auto loans typically have shorter repayment terms than mortgages, ranging from 3 to 7 years.
Auto loans are a standard financing option for individuals and families who cannot afford to pay cash for the vehicle’s purchase price. Instead, these loans allow you to put a down payment towards the car and finance the remaining balance.
If you use a collateralized auto loan, lenders can repossess your car if you fail to make on-time payments. Read more about how to apply for an auto loan today.
3. Secured Credit Cards
A secured credit card is a type of credit card that requires the borrower to deposit a security deposit with the lender. This deposit serves as collateral for the credit card.
The credit limit of a secured credit card is usually equal to or less than the amount of the security deposit. Secured credit cards are designed to help individuals with limited or damaged credit histories build credit.
4. Life Insurance Loans
Life insurance policies with cash value components may allow policyholders to borrow against the accumulated cash value. The policy's cash value secures these loans. The borrower can borrow up to a certain percentage of the cash value, and interest is charged on the loan amount.
Life insurance loans can be a valuable source of funds for policyholders during an income drought or financial need. They are highly flexible and convenient because the funds are readily available within the policy.
Before borrowing against your life insurance policy, you should understand the implications and how it affects your financial future.
5. Car Title Loans
Car title loans are short-term loans in which the borrower uses their vehicle title as collateral. The lender provides a loan based on the vehicle's value and holds the title until the loan is repaid.
Car title loans are typically high-interest loans with short repayment terms. They can be a tempting option for individuals facing financial emergencies, but they can also be extremely risky. If you fail to repay the car title loan on time, they may lose their vehicle through repossession.
Read Also: Here’s How a Payday Loan Works
7 Steps to Get Your Secured Loan
The application process for getting a secured loan will vary depending on how much you need to borrow, what you use as collateral, and your credit history. Here are seven steps to get the secured loan you need today:
1. Assess your creditworthiness: Lenders will evaluate your credit history and credit score to determine your creditworthiness. Borrowers with a high credit score will be rewarded with lower interest rates and better terms. You can boost your credit score before applying for a loan to get healthier terms.
2. Choose the type of secured loan: The next step involves determining why you need the financing. If you need to purchase a new car, consider your auto loan options. Select the type of secured loan that best matches your needs: mortgage, vehicle loan, secured credit card, life insurance loan, or car title loan.
3. Find the best lender: The four most important variables in a secured loan are your borrowing amount, interest rate, term, and collateral. Research and compare offers from different banks and lenders to find the most favorable interest rates and overall loan terms.
4. Provide collateral: As part of securing your loan, you will need to agree on the asset to be used as collateral. For mortgages, this is usually your home. However, some secured loans, like a secured credit card, have flexibility in the amount and type of items you can use as collateral (some allow you even to use jewelry or art). Make sure you are absolutely comfortable utilizing the item you select as collateral because there is a risk of loss if you default.
5. Complete the loan application: Once you have completed your research, figured out what type of loan you want, negotiated terms, and determined your collateral, it is time to complete your loan application. Many applications are now online forms. Submit the required loan application forms and documentation.
6. Undergo credit and background checks: As part of the application, you will have to have a hard credit inquiry. Lenders will conduct credit and background checks to verify your identity and financial history as part of this assessment.
7. Loan approval and disbursement: Once the lender performs their due diligence on you and your loan application, your application will be approved. From there, the lender will usually disburse the loan funds via direct deposit into your savings or checking account or issue you a check.
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Pros of a Secured Loan
- Lower interest rates: Secured loans generally come with lower interest rates compared to unsecured loans due to the reduced risk for the lender. Lower interest rates reduce the cost of capital when borrowing funds. (Get your free annual credit report at AnnualCreditReport.com).
- Access to larger loan amounts: By using collateral, you can qualify for more substantial loan balances. This increased loan size might give you access to the cash you need.
- Improved creditworthiness: Making timely payments on a secured loan can help improve your credit score. Your credit report houses information about your on-time payments, types of loans, and length of credit history. Making payments on time can improve your FICO and VantageScore.
- Potential for building equity: Secured loans such as mortgages and auto loans let you build equity in assets over time. If ever you need to sell your home or car, you will earn the amount of equity you own.
Cons of a Secured Loan
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- Risk of losing collateral: If you default on a secured loan, you risk losing the asset used as collateral. Losing collateral can be an excruciating process, so make sure you put up something you are comfortable losing as collateral. (Read more about how to manage consumer debt).
- Limited flexibility: Secured loans may have more stringent repayment terms and less flexibility compared to unsecured loans. For example, secured payday loans or credit cards may only relax initial terms once several on-time payments have been made. (Read more about the 5 C’s of Credit).
- Potential for financial hardship: Losing collateral can have a significant and compounding negative impact on your financial situation. If you use cash or jewelry as collateral for a secured credit card and lose your deposit, this could put you in a worse financial predicament. (Read more about how to pay off car loans quickly).
- Increased emotional distress: The loss of a valuable asset, like a home, car, or cash, can significantly impact your mental health and damage your net worth. Make sure you can handle the emotional distress of potentially losing any collateral before using it to secure a loan. (Read more about saving an emergency fund).
Smart Summary
A secured loan is a type of loan where you pledge an asset as collateral to secure a loan. Secured loans offer both advantages and disadvantages. While they provide access to lower interest rates and larger loan amounts, they also carry the significant risk of losing your collateral if you default on your loan. Before taking out any secured loan, you should carefully consider the terms, conditions, and impact on your personal finances.
