What Is an Unsecured Loan?
Whether your loans are secured or unsecured may seem inconsequential if your credit is good. You write a check to pay them off every month regardless. The difference can have an effect on your finances, however, in small, subtle ways. Overall, one type of loan is not necessarily better than the other. A healthy balance between the two is what most lenders look for.
As the name suggests, secured loans are the antithesis of unsecured loans. You've pledged something as collateral, and if you default on the loan, the lender can seize that collateral and either sell it or keep it to satisfy your debt. Secured loans are also known as installment loans because they typically involve regular, equal payments. Examples include your mortgage – secured by the property – and your auto loan, secured by your car.
Unsecured loans require a leap of faith on the part of the lender. With no collateral anchoring the loan that the lender can take back if you don't pay, it must rely entirely on the likelihood that you'll honor the debt. It essentially comes down to taking your word for it that you'll make payment. Obviously, your word has more value if you have a proven history. In the event of default, unsecured creditors have more of an uphill battle than secured creditors. These loans involve enforceable contracts, but taking a borrower to court to enforce the contract and using the resulting judgment to try to collect requires additional time and expense. At your death, unsecured creditors are the last in line to receive payment from your estate as part of the probate process.
Interest rates associated with unsecured loans are typically higher than those for secured loans. No matter how great your credit score is, the lender wants something in return for taking a chance, and this often comes in the form of slightly higher fees. All unsecured loans – such as credit cards or revolving lines of credit – don't come with the same interest rates, however. Just as with secured auto loans, the better your credit is, the less of a rate you'll pay – although you'll typically still pay more than you would if the loan were secured.
Your Credit Score
Having only secured debt isn't good for your credit score. Ten percent of your score is based on the balance between your secured debt and your unsecured debt. In theory, at least, this shows that you're savvy with all types of credit and can handle any type of loan – which means you're a better credit risk and are more likely to qualify for unsecured loans.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.