Secured vs. unsecured loans: What you should know

Loans and lines of credit can provide you with funding to cover large expenses—but they aren't all alike. A secured loan requires you to offer security or collateral to borrow money; an unsecured loan doesn't. Understanding the difference between a secured vs. unsecured loan can help you decide which one makes the most sense for achieving your financial goals.

What is a secured loan?

A secured loan is any loan that's protected by an asset or collateral. These loans can be offered by brick-and-mortar banks, online banks, credit unions and non-bank lenders.

Mortgages and home equity loans are two examples of secured loans that use a specific asset, i.e., a home, as collateral. Personal loans and lines of credit can also be secured.

Secured personal loans can be used to fund large expenses, pay for home repairs or improvements, consolidate debt or to meet other financial goals. The collateral gives the lender reassurance that the money they’ve lent will be repaid. If a default happens (meaning the borrower fails to pay), the lender can assume ownership of the collateral to make up for any financial losses associated with non-payment of the loan.

If you have no credit or want to rebuild your credit, some lenders offer credit builder loans, which allow you to use your savings account or certificate of deposit (CD) balance as collateral in building a credit history. At BMO, you can open a credit builder loan with as little as $1,000, which is deposited into a CD. Your timely payments are reported to the credit bureau, which helps build a positive credit history. When the loan is repaid, you’ll receive the $1,000 you invested plus interest.

What is an unsecured personal loan or line of credit?

An unsecured personal loan or line of credit doesn't require the borrower to offer any security or collateral upfront. These loans can be offered by banks and credit unions, as well as online lenders. Unsecured personal loans and lines of credit can be used for many of the same purposes as secured personal loans, including debt consolidation, home upgrades or planning a vacation.

An unsecured loan or line of credit can be riskier for the lender since there's no security backing up the loan. That means if the borrower defaults, there's no collateral that can be claimed to pay off the debt.

Key differences between secured and unsecured loans

The main difference between secured and unsecured loans is the collateral requirement. Aside from that, there are other things that set secured and unsecured loans apart from one another, such as:

• Qualification requirements
• Interest rates
• Repayment terms

Qualifying for a secured loan vs. an unsecured loan may be easier in terms of qualification requirements. Lenders may be willing to accept a lower credit score or higher debt-to-income (DTI) ratio (how much of your income goes to debt repayment each month) when there's collateral in place to secure the loan. Secured loans may also offer lower interest rates for borrowers compared to unsecured loans since there's collateral backing up the debt. With unsecured loans, a borrower will need to have a higher credit score to qualify. Both types of loans can charge fixed or variable interest rates, depending on what the loan is used for.

The repayment terms of a secured vs. unsecured loan can depend on the amount you're borrowing and the interest rate. The larger the loan amount, the longer the repayment term may last, though it might be a more affordable option. A longer repayment term could mean a lower monthly payment, but you may pay more in interest over the life of the loan.

How much you pay in interest can also depend on whether you’re choosing a secured or unsecured loan vs. a line of credit. With a loan, you receive a lump sum of money and repay interest on the entire amount. A line of credit, on the other hand, only charges interest for the amount of your credit limit you use.

Secured vs. unsecured loan: Which one is right for you?

Whether it makes sense to borrow using a secured or unsecured loan can depend on the situation. For example, some of the most common reasons for getting a secured loan include:

• Borrowing against your home equity (through a home equity loan or home equity line of credit)
  
• Purchasing business equipment

You may also need to consider a secured personal loan if you're trying to build credit history or your credit history isn't sufficient to allow you to qualify for an unsecured loan.

With a good credit score, an unsecured personal loan or line of credit could make sense if you need money quickly or don't necessarily need the money to buy a large tangible asset such as a home. For example, you could use unsecured loans to pay for:

• Home improvements or repairs
• Debt consolidation
• A vacation or wedding
• New furniture
• An unexpected emergency

A small unsecured loan might also make sense if you have an unexpected expense or need extra funds temporarily. The fact that you don’t need to offer collateral for an unsecured loan is an added benefit and makes the process easier.

Once you've decided whether to choose a secured loan or an unsecured loan, comparing loan options is the next step. With secured loans, consider the collateral or security requirements and the loan terms. It's important to make sure you can pay the loan back, so you don't run the risk of losing your collateral.

With either type of loan, pay attention to the interest rates, fees, and repayment terms. The best loan, whether secured or unsecured, is the one that fits both your borrowing needs and your budget. If you're ready to take the next step, visit us in branch or online to explore loans and lines of credit options.