When shopping for loans, there are several different types available. Some loans are better for certain situations than others. Two of the main types of loans available today are secured and unsecured loans, and it is important when shopping for loans that you know the difference between the two, and when it is better to use which.
What is a Secured Loan?
A secured loan, also called a secured debt, is a loan that is taken out wherein the borrower has to give some form of collateral to the lender. Collateral works as insurance for the lender in case the borrower falls behind on payment of the loan. If the borrower never catches up on their payments, the loan defaults and the lender gets to keep the collateral. Thus, the lender gets their money back, just not in the form of money until they sell the collateral that they have repossessed.
If the collateral does not bring the same amount of money as the loan, then the lender can obtain a deficiency judgment against the borrower. These can wreak havoc on the borrower’s credit, so these loans are not to be entered into lightly. This is a common reason why many home foreclosures happen.
Examples of typical secured loans are car loans and mortgages, so they are very long-term, and if you are unable to pay them, then the consequences will generally be more severe than that of an unsecured loan. Furthermore, this also means that by nature they are for much larger sums of money than unsecured loans.
What is an Unsecured Loan?
An unsecured loan is a loan taken out by a lender that does not require any form of collateral. These generally require higher credit scores than a secured loan, because if the borrower does not make good on the debt, it is a complete loss for the lender.
Unsecured loans come in many different forms such as debt consolidation loans and some credit cards. If you need a more short-term loan to help through a tough time, or you want to take out a loan to help improve your credit score, then an unsecured loan affords more opportunities to do so. However, that does not mean that these loans can be taken out without consideration for everything that comes with them. Defaulting on a short term loan, or falling behind on your payments, can stay on your credit report for as long as seven years before you get a fresh start.
Just like with a secured loan, if you default on an unsecured loan, your lender has the right to take legal action against you as well. If they choose to sue you, then this could result in a civil action case that would result in your credit score receiving a penalty.
Where Does My Credit Come into Play?
Generally, you initially need a higher FICO score to take out an unsecured loan than a secured loan in the first place, since they pose greater risks for the lender. However, if you do not make a payment on either an unsecured loan or a secured loan, it has the same negative effect on your score. No matter whether you miss a payment on a secured loan or an unsecured loan, your score will take a hit of anywhere from 60 to 110 points at a time, according to tax lawyer Mack Mitzsheva.
However, the loans differ in that whenever you default on an unsecured loan, then the account is simply called past due until 150 days have passed, then the lender simply writes the loan off as a loss. When you default on a secured loan and the lender has to possess the collateral or foreclose your home, that can damage your credit score severely. The loans also differ in that secured loans generally have lower interest rates despite the fact that they have significantly higher principals than unsecured loans, because of the presence of collateral.
Before you decide to take out one loan or the other, you should know your credit score and know how applying for loans will also affect your credit score. When you check your own credit score, you are making a soft inquiry about that score. These soft inquiries should not cost you any money, and will neither positively nor negatively affect your credit score. However, whenever you apply for a loan, both unsecured and secured lenders must make hard inquiries about your credit. These hard inquiries do lower your credit score, typically between 5 and 20 points.
If you can take out and consistently make your minimum payments for either an unsecured or secured loan, then your credit score will massively improve. When FICO crafts your credit score, they consider several elements, three of which include your financial history, the various types of credit that you have, and the length of your credit history.
In opening and promptly paying either a secured or unsecured loan, you increase your available credit, diversify your credit portfolio, and expand your credit history. Furthermore, because secured loans are typically long-term, you will have an older trade line which will also increase your score after a few year of solid payment.
Be aware that these advantages only reveal themselves whenever you have made good on your loans, so be sure not to fall behind on payments, or your score will suffer. Though it’s definitely an option that can help you, be very careful before you pursue a loan to consolidate debts and improve your credit score.
Now you have the power to make a more informed borrowing decision. Knowing your credit score, what types of loans are available, and the consequences that come with defaulting on those loans puts your financial future in your hands, rather than leaving it up to a lender. You can be your own financial advisor, and borrow your way to a financial future that leaves you with a credit score that you can not only be proud of, but have immense purchasing power with.