What are secured loans and how do they work?

A secured loan is a loan that is secured by collateral. Since you must use one of your assets to secure the loan, secured loans are easier to obtain than unsecured loans. They can be an effective way to get the funds you need, but they come with risks.

Here’s what you need to know about secured loans before you apply.

What is a secured loan and how does it work?

Secured loans are loans that are protected by collateral. This means that when you apply for a secured loan, the lender will want to know which of your assets you plan to use to secure the loan. The lender will then place a lien on this asset until the loan is repaid in full. If you fail to repay the loan, the lender can claim the collateral and sell it to recoup the loss.

It is important to know precisely what you are promising and what you stand to lose before taking out a secured loan.

Secured loan vs unsecured loan

Some loans, like personal loans, can be unsecured or secured, depending on the lender. If you don’t qualify for the unsecured option or are looking for the lowest possible interest rate, check to see if the lender offers a secured option for the loan you’re interested in.

When it comes to choosing a secured loan over an unsecured loan, several factors should be considered. Here are some of the differences between the two and some pros and cons of each type of loan:

Secure loan Unsecured loan
Credit score Credit score and financial health will determine eligibility Credit score and financial health will determine eligibility
Interest rate Generally lower Generally higher
Penalties Collateral can be seized, credit score will drop Missed payments will go into collection, credit score will drop
Types of loan Mortgages, HELOC, car loans, business credit cards and guarantees, etc. Unsecured credit cards, student loans, personal loans, etc.

Types of secured loans

Lenders want to know they have leverage once you walk away with their money. When they place a lien on your collateral, they know that in the worst case scenario, they can take possession of the assets you are using as collateral. This does not guarantee that you will repay your loan, but it does give lenders a greater sense of security and gives the borrower more impetus to repay the loan.

Types of secured loans include:

  • Mortgage: With a mortgage, you put your house or property as collateral to buy that house. If you don’t make the payments, your home may be foreclosed.
  • Home equity line of credit: A home equity line of credit (HELOC) gives you access to the equity in your home in the form of a line of credit, like a credit card. With a HELOC, you also put your house up as collateral.
  • Car loans: When taking out a loan to pay for a car or any other vehicle, your vehicle will serve as collateral. If you don’t make payments on time and in full, your vehicle could be seized.
  • Ready for a pitch: A land loan is used to finance the purchase of land. This type of loan uses the land itself as collateral.
  • Commercial loan: Business loans can be used to buy equipment, pay salaries or invest in business projects. When you take out a business loan, there are a number of things you can use as collateral. For example, inventory, equipment, or your land or building can be used to secure a business loan.

What types of collateral are used to secure a secured loan?

Secured loans are usually the best way – and often the only way – to get large sums of money. Almost anything can be accepted as collateral, as long as it is permitted by law. Lenders prefer assets that are easy to collect and easily convertible into cash. What you use as collateral will likely depend on whether your loan is for personal or business use. Here are some examples of warranties:

  • Real estate, including the equity in your home.
  • Cash accounts (retirement accounts generally do not qualify).
  • Cars or other vehicles.
  • Machinery and equipment.
  • Investments.
  • Insurance conditions.
  • Valuables and collectibles.

How can I apply for a secured loan?

When it comes to getting a secured loan, follow these steps before you apply:

  1. Check your credit: Before applying for a loan, you will want to check your credit report. Whether you are approved for the loan largely depends on your creditworthiness, and although secured loans may have less stringent credit requirements than unsecured loans, it is still important to know your credit score for qualification. You can check each of your credit reports for free every 12 months (or weekly until April 20, 2022) with AnnualCreditReport.com.
  2. Check the value of your assets: The value of the asset you want to use as collateral will usually determine how much you can borrow with a secured loan, so get an appraisal or research estimated resale value before researching lenders.
  3. Take a tour of the different lenders: Shopping around allows you to compare lenders’ rates and fees. Many lenders offer prequalification, which lets you see what you’re entitled to without impacting your credit. It’s usually best to be prequalified with at least three lenders.
  4. Request the loan from the most competitive lender: If you are applying with an online lender, the whole process can usually be done online. If you are applying through a bank or credit union, you may need to go to a physical location.

What happens if you fail to repay a secured loan?

After a few missed payments on a secured loan, the lender is likely to repossess the asset used to secure the loan. In many states, the lender is not required to give you notice of repossession. To make matters worse, repossession is not the end of the matter. If the repossessed asset does not sell enough to cover your loan amount, you are responsible for the difference.

For example, if you owe $20,000 when you stop making payments on a boat loan and the boat is repossessed and sold for $15,000, you will owe the lender the remaining $5,000. The repossession stays on your credit report for seven years.

If you miss payments on a mortgage, home equity loan, or business loan, the lender has a longer process to get their money back. In about half of the US states, a lender must go to court to foreclose on a property. In the other half, the lender is required to provide you with a foreclosure notice. Either way, it’s a good idea to call your lender as soon as you know you’ll be missing payments to see if you can negotiate a loan modification that will allow you to keep your home or business.

Next steps

If you are interested in a secured loan, the most important step you can take is to do the necessary research and compare lenders. It’s also important to have a plan in place to repay your loan on time and in full to avoid losing your collateral.

Although secured loans are more risky than unsecured loans, they can be useful tools as long as you maintain your monthly payments.

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