A secured loan is a type of loan that is backed by collateral. This means that the borrower pledges an asset as security for the loan. If the borrower defaults on the loan, the lender can seize the collateral to recover their losses. Secured loans are commonly used for large purchases like homes, cars, and boats. They come with certain advantages and disadvantages compared to unsecured loans.
How Do Secured Loans Work?
With a secured loan, the collateral acts as insurance for the lender. If the borrower stops making payments, the lender can take possession of the collateral, sell it, and use the proceeds to recover their losses. This lowers the risk for lenders, allowing them to offer lower interest rates and more flexible terms compared to unsecured loans.
To get a secured loan, the borrower provides the lender with an asset to secure the debt. The lender places a lien on the collateral until the loan is fully repaid. Common assets used as collateral include:
- Real estate – Most mortgages and home equity loans use the home as collateral. The property acts as security for the debt.
- Vehicles – Car, boat, and RV loans commonly use the vehicle as collateral. The lender can repossess the vehicle if you default.
- Cash accounts – Banks may accept deposit accounts like savings or CDs to secure a personal loan.
- Investments – Brokerage accounts and certain securities like stocks and bonds can collateralize a loan.
- Insurance policies – Permanent life insurance policies with cash value may allow you to borrow against them.
- Valuables – Pawn shops provide loans secured by jewelry, electronics, tools, and other personal items.
The lender will assess the value of the collateral and your creditworthiness to determine loan eligibility and terms. After approving a secured loan, the lender will perfect their interest in the collateral by filing documentation like a mortgage, lien, or title. This gives them the legal right to seize the asset if you fail to repay.
Pros and Cons of Secured Loans
Secured loans offer several advantages but also come with some risks to weigh.
Pros
Lower interest rates – Secured loans tend to have lower interest rates because the collateral reduces the lender’s risk.
Higher approval odds – The collateral makes lenders more willing to approve borrowers with lower credit scores.
Larger loan amounts – You may be able to borrow more with a secured loan than an unsecured loan.
Longer terms – Secured loans like mortgages can have repayment terms of up to 30 years.
Predictable payments – Many secured loans have fixed rates, keeping payments consistent.
Cons
- Risk of repossession – Failing to repay could result in the lender seizing your assets.
- Closing costs – You may have to pay appraisal, title, and filing fees when taking out the loan.
- Difficult to discharge – Secured debts are harder to discharge in bankruptcy than unsecured debts.
- Asset restrictions – Your lender may place restrictions on how you can use the collateral while repaying the loan.
- Value depreciation – The resale value of assets like cars tends to decrease over time.
Consider both the advantages and risks before deciding if a secured loan is right for your situation. Be sure you can comfortably afford the payments to avoid repossession.
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Types of Secured Loans
Many types of loans can be secured by collateral. Common secured loan varieties include:
Mortgage Loans
Mortgages allow borrowers to purchase real estate by using the property as collateral. It is the most common type of secured loan. If you default, the lender can foreclose on the home.
Mortgages feature low interest rates and long repayment terms, making homes affordable. The size of the loan is based on the home’s value and your down payment. Many mortgages have fixed rates helping stabilize housing costs.
You can also use an existing home as collateral through a home equity loan or home equity line of credit (HELOC). These loans allow you to borrow against the equity in your home.
Auto Loans
Auto loans are used to finance new and used car purchases. The vehicle serves as the collateral. Auto loans allow you to spread out the cost over 2 to 6 years. Interest rates are generally lower for new cars.
If you stop making payments, the lender can repossess your car. Refinancing your auto loan could potentially lower your interest rate and monthly payment. But falling behind on payments can quickly put your vehicle at risk.
Securities-Backed Loans
Securities like stocks, bonds, and mutual funds can be used as loan collateral through a securities-based loan or pledged asset line. This allows you to access their value without liquidating your investments and paying taxes and penalties.
The size of the loan depends on the value of your securities and creditworthiness. If your investments decline, you may need to provide additional collateral. Failing to do so could result in the forced sale of your securities.
Cash-Secured Loans
Banks may offer cash-secured loans backed by your savings accounts, CDs, or money market accounts. The lender places a hold on your funds equal to the loan amount for the duration of the repayment term.
The funds in the deposit account serve as security for the loan. This allows lenders to offer better terms than they may approve for an unsecured loan. If you default, the lender can seize the funds to recover their losses.
401(k) Loans
You can borrow against your existing 401(k) balance through a 401(k) loan. These loans avoid taxes and penalties but reduce your retirement savings. If you leave your job, the loan must usually be repaid in full or it is treated as a withdrawal.
The size of the loan is limited to either 50% or $50,000 of your vested 401(k) balance. If you fail to repay the loan, it is considered an early withdrawal subject to taxes and penalties.
Pawn Loans
Pawn shops offer small short-term loans secured by your personal property. Common collateral used in pawn loans includes jewelry, tools, electronics, musical instruments, and collectibles.
The pawnbroker will appraise your items and extend a loan amounting to a fraction of their resale value, often 25% to 50%. The duration is usually 30 days to one year. Rates can be very high. If you do not repay the loan plus fees, the pawn shop will sell your collateral.
Other Secured Loan Varieties
- Boat loans – Financing for a new or used boat purchase. The boat serves as collateral.
- Business loans – Funding for businesses using assets like equipment, accounts receivable, or real estate as security.
- Jewelry loans – Short-term financing from jewelry stores secured by jewelry collateral.
- Hard money loans – Asset-based financing for real estate investors secured by the property.
- Furniture loans – Store financing that uses the furniture as collateral until paid in full.
- Title loans – Small short-term loans using your car title as collateral without surrendering the vehicle.
What Credit Score is Needed for a Secured Loan?
The minimum credit score for secured loans varies by lender. However, secured loans often have lower credit requirements than unsecured alternatives. Adding collateral provides security for the lender, allowing them to take on more credit risk.
While individual lender requirements differ, here are general credit score guidelines for secured loans:
- Mortgage – 620 minimum for conventional loans, 500-579 for FHA loans
- Auto Loans – 600 for new cars, 500 for used cars
- HELOCs – 620+ for the best terms
- Securities-Backed – No minimum, but 700+ scores get the lowest rates
- Pawn Loans – No minimum required since loan based on collateral value
- 401(k) Loans – No credit check required
Good credit improves your chances of approval and helps you qualify for the lowest rates. But poor credit does not necessarily disqualify you from a secured loan if you have assets to pledge as collateral.
How to Get a Secured Loan
Follow these key steps when seeking a secured loan:
1. Check your credit – Request copies of your credit reports so you can review your credit scores and fix any errors before applying.
2. Compare lenders – Research different banks, credit unions, online lenders, and other financing companies offering secured loans for the type of asset you plan to use as collateral. Compare interest rates, loan amounts, fees, and eligibility criteria.
3. Determine collateral – Decide which asset you want to pledge as security for the loan. Make sure it meets the lender’s collateral requirements. Have the asset appraised to verify its current market value if needed.
4. Apply for preapproval – Many lenders allow you to apply for preapproval to check potential loan terms and eligibility before fully applying. Preapproval is recommended for mortgages and car loans.
5. Submit loan application – Compile all required documents and complete the lender’s loan application. Be prepared to pay any application fees.
6. Close on the loan – If approved, you will finalize loan documents and the lender will perfect their security interest in the collateral before releasing funds.
Getting preapproved can help you shop for houses or cars within your budget. Be aware that taking lots of inquiries searching for a secured loan may damage your credit score temporarily.
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What if You Default on a Secured Loan?
Defaulting on a secured loan can have serious consequences. If you miss payments, the lender may:
- Report missed payments to credit bureaus, damaging your credit scores
- Charge late fees and penalties
- Raise your interest rate
- Demand immediate repayment of the full balance
- Take possession of the collateral
- Sue you for any loan balance remaining after liquidating the collateral
Mortgage Default
If you cannot pay your mortgage, the lender can foreclose on your home. Foreclosure is a legal process where your home is auctioned off to pay the loan balance. You must vacate the property after a foreclosure.
It may take over a year if you go through the entire foreclosure process. This severe delinquency wrecks your credit. Any remaining loan balance after the home is sold becomes an unsecured debt you still owe.
Auto Loan Default
Missing car payments gives the lender right to repossess your vehicle. They may hire a repossession company to take the car without warning. The car is then sold at auction, with proceeds paying down your loan.
You are responsible for any deficiency between the outstanding loan balance and resale value. The repossession stays on your credit report for seven years. You will have difficulty getting approved for another auto loan.
Defaulting on Other Secured Loans
If you default on a HELOC, securities-backed loan, or cash-secured loan, the lender can seize your collateral. Any remaining balance would become an unsecured debt subject to collection actions. Defaulting could make it challenging to obtain financing in the future.
Alternatives to Defaulting
To avoid repossession or foreclosure, take these steps if struggling to pay a secured loan:
Contact your lender – Inform them of financial hardship and request alternative arrangements before missing a payment. Options may include forbearance, modifications, partial claims, and repayment plans.
Use home equity – If eligible, take out a HELOC at a lower rate to pay off credit cards or other high-interest debts reducing monthly expenses.
Refinance – You may qualify to refinance your mortgage, auto loan, or other secured debts at a lower interest rate to reduce payments. Recent home value growth enables many to refinance at lower LTV ratios.
Sell the asset – As a last resort, you can voluntary surrender or sell the collateral to pay off the secured loan and avoid repossession or foreclosure. This prevents further damage to your credit.
Seek credit counseling – Non-profit credit counseling agencies can provide advice and arrange debt management plans, consolidation loans, or housing counseling to help avoid default on secured debts.
If you do lose collateral to repossession or foreclosure, work on rebuilding your credit score over time before attempting to qualify for major financing again in the future.
Pros and Cons of Defaulting
Not making payments on a secured loan can severely damage your finances for years. However, some may see limited pros in letting default occur:
Pros
- Stops debt obligations temporarily
- May negotiate settlement for less than the full balance
- Can retain collateral longer before repossession
Cons
- Foreclosure or repossession of collateral
- Serious damage to credit history
- Continued responsibility for deficiency balance
- Higher borrowing costs in the future
- Increased stress and financial hardship
- Legal consequences including wage garnishment or liens
Unless facing dire circumstances like serious medical issues, job loss, or high interest rates with predatory terms, defaulting on a secured loan can do much more harm than good in the long run.
Conclusion
Secured loans require pledging an asset as collateral to reduce risk for the lender. This allows borrowers to access larger loan amounts with lower interest rates and more flexible qualification criteria compared to unsecured loans. Common assets used as collateral include real estate, vehicles, securities, bank accounts, insurance policies, and valuables.
While secured lending comes with the risk of repossession, it opens doors to affordable financing that may not otherwise be available such as mortgages, auto loans, and lower-rate debt consolidation. Your credit still factors into the approval decision and terms. Those with very poor credit have the highest risk of default.
Carefully consider whether securing debt with your property makes sense. Try to only borrow what you can comfortably afford. Make payments on time to avoid repossession and damage to your finances and credit. Explore alternatives if you anticipate having trouble repaying a secured loan. In most cases, meeting your obligations should take priority over surrendering your assets if at all possible.
FAQs About Secured Loans
1. Why would someone get a secured loan?
The main reasons for choosing a secured loan are to get a larger loan amount, lower interest rate, longer repayment term, or flexible qualifying requirements compared to unsecured loans. The collateral provides security for the lender, allowing them to comfortably offer more favorable loan terms.
2. How does collateral work in secured lending?
Collateral acts as repayment insurance for the lender in case you are unable to pay back a secured loan. The lender can seize and sell the collateral to recoup losses if you default. The collateral value needs to equal or exceed the loan amount. The asset must also meet the lender’s security requirements.
3. What happens after a secured loan default?
With secured loans, missing payments leads to repossession of collateral like cars and foreclosure on property used to secure the debt. Your credit scores will be damaged for years, and you will be responsible for any loan deficiency left after the lender sells the seized asset. This deficiency balance becomes an unsecured debt.
4. What types of assets can be used as collateral?
Common assets used as collateral for secured loans include real estate, vehicles, securities and investments, deposit accounts, insurance policies with cash value, valuables like jewelry and collectibles, and business equipment. The lender looks at the asset’s worth, ease of valuation, marketability, and eligibility as collateral when making decisions.
5. Are secured loans hard to get?
Secured loans are generally easier to get than unsecured alternatives because the collateral reduces the lender’s risk. Having assets to secure the debt improves the chances of approval for borrowers with lower credit scores who may not otherwise qualify. Minimum credit score requirements for secured loans tend to be lower as well.
6. Should I use collateral I already own for a better loan?
Pledging assets you already own instead of making a larger down payment could make sense in some cases. For example, using stocks as collateral for a securities-backed loan to purchase a home while keeping your down payment smaller may enable you to avoid capital gains taxes and preserve your cash. Run the numbers to see if the better rates and terms outweigh the risks involved with secured lending.
7. Can I get a business loan without collateral?
While secured financing is common, small businesses can get unsecured loans through SBA-guaranteed programs including 7(a), Express, CDC/504, and microloans. Startups and companies with short credit histories may find it easier to qualify for SBA loans. Amounts range from $500 to $5 million. Terms are 6-25 years for working capital and equipment and up to 25 years for real estate.
8. Should I pay off a secured loan early?
Paying off a secured loan faster than required can save money on interest and release your collateral sooner. But you generally don’t have to pay secured debts early. Consider your opportunity cost. You may lose tax benefits for the interest paid or be able to earn more investing extra funds elsewhere. Weigh this against interest savings and your loan’s prepayment policy before deciding.
9. Can I get a secured loan to build credit?
Yes, secured credit cards and share-secured loans that require funds on deposit to serve as collateral are available from credit unions and some banks. Making on-time payments shows you can responsibly manage credit and helps build your scores. Just be sure to avoid high fees. After 1-2 years of consistent payments, you may qualify for unsecured credit and have your deposit returned.
10. Should I use my home as collateral for debt consolidation?
Using home equity via a HELOC to consolidate higher-rate unsecured debts like credit cards can make sense in some situations. Benefits include deducting interest on your taxes and potentially cutting your total interest costs. But removing equity from your home is risky if you later have trouble making payments. Consider all your options and run the numbers with a consolidation calculator before deciding.
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