Why Does An Unsecured Loan Have A Higher Interest Rate Than A Secured Loan?

Learn all about Unsecured and Secured Loans.

You are required to provide some form of collateral when you take out a secured loan. This can be your home or your car. The collateral acts as security for the lender and protects them from loss if you fail to repay the loan. Whereas an unsecured loan does not use any collateral to protect the lender. They may, however, be considered higher risk for the lender because of this clause and may have less favorable interest rates and terms.

What is a Secured Loan?

According to the secured loan meaning, when you take out a secured loan, you agree to provide the lender with some kind of collateral. This collateral should have monetary value equivalent to or greater than the amount you are borrowing from the lender. The collateral will act as a safety net for the lender, protecting them from loss if you end up being unable to pay for the loan.

Secured loans examples also include mortgages, home equity lines of credit (HELOCs) and vehicle loans. For mortgages and HELOCs, your house is used as collateral whereas for auto loans, the vehicle you are trying to purchase is the collateral.

There are other types of secured credit which can include secured credit cards. These require you to deposit money equal to your credit limit in an account that is held by the lender. Secured credit also includes title loan which can allow you to borrow against your vehicle’s title value.

How Does a Secured Loan Work?

A secured loan will stay intact as long as you keep repaying the loan according to your agreement with your lender. If you continue making your payments, you will get to keep your collateral while building your credit at the same time. Once the loan is paid off, the collateral will be yours.

Since secured loans ensure that the lender has something of value if you ever fail to repay the loan, they are generally considered to be lower risk loans. You can borrow large sums at lower rates and better terms if you opt for a secured loan. The collateral can also make it easier to qualify for the loan even if you do not have an excellent credit score.

For example, even with a credit score as low as 500, you can qualify for certain kinds of FHA mortgages.

What Happens if you Default on a Secured Loan?

The lender will have the legal right, as per the agreement you signed with them, to take possession of your collateral if you default on a secured loan. If you default on your mortgage, the bank will foreclose your house while defaulting on your car loan means the lender can repossess your car.

If you do not repay your debt, it can negatively affect your credit score and credit history. This applies for all kinds of debt, including your mortgage, car loan and other types of secured loans.

Defaulting on your secured loan can be especially bad since the default stays on your credit report and can continue affecting your score for a long time.

For example, foreclosure and repossession history stays on your credit report for seven years even if their impact on your credit score diminishes over time.

What is an Unsecured Loan?

An unsecured loan is not attached to any collateral. The lender will only have the assurance that you will repay the debt by your creditworthiness and your word. Common types of unsecured loans include student loans and personal loans. Another unsecured loan example is credit cards, also known as revolving credit, where you borrow and repay the borrowed amount monthly.

How do Unsecured Loans Work?

Just like with a secured loan, taking out an unsecured loan means you and the lender agree to certain terms for repayment which will include an interest rate and the time you will have to pay back the debt. However, since there is no collateral for lenders to claim if you end up defaulting on the loan, unsecured loans are considered to be higher risk for lenders.

In order to qualify for an unsecured loan, you are required to have a good credit standing and a high credit score. It might be more difficult to get approved for an unsecured loan and there is a chance that the loan might come with a higher interest rate and less favorable terms.

What Happens if you Default on an Unsecured Loan?

Whenever you skip repaying a debt, it leads to bad credit scores. Even though unsecured loans do not have any collateral that the lender can claim if you do not end up paying, they are with recourse if you default on the loan. Lenders can put your account into collections and carry out legal action against you in order to recoup some or all of the debt. Some lenders might also end up filing lawsuits in order to recoup monies owed which could result in a civil judgement that can negatively impact your credit.

Moreover, late payments that get reported will also have a negative impact on your credit and future potential lenders can see that as a red flag if they are looking to extend your credit.

Whatever kind of loan default it is, it will always negatively affect your credit scores. If there are any collections and civil judgements, they will show on your credit report for seven years from the date the account first went delinquent or the date the ruling was done against you.

What Type of Loan is Right For you?

The main difference between secured and unsecured loans is the lender requiring collateral to secure the loan. However, determining which loan is right for you depends on a few factors, including how much you need to borrow and your credit score.

Secured loans allow you to borrow large amounts of money at lower rates than unsecured loans. This is because the lender is more confident with a secured loan that they will not lose money even if you fail to repay your loan. However, if you default, you end up putting your property at risk whereas unsecured loans do not put your property at risk. However, they can be more difficult to get and have higher interest rates and compared to secured loans, shorter terms.

Why Does an Unsecured Loan Have a Higher Interest Rate Than a Secured Loan?

The main reason an unsecured loan has a higher interest rate is because of the risk factor. By asking for no collateral, the lender is putting himself at risk. If you fail to repay your debt, your lender will be the one who will have to suffer. This is why the interest rates for an unsecured loan are higher. Since you are putting your property in a mortgage secured loan and your car in a car secured loan, the lender knows they have something of yours they can take to recoup the debt. Since that is not the case with an unsecured loan, the risk is more for the lender.

A key rule to remember in the world of lending: the higher the stakes, the higher the interest rates.

Final Thoughts

Before you make a decision on how to use your credit, it can be helpful to check your credit report and scores. Knowing your credit score and the contents of your credit report can help you make a more informed borrowing decision.

Both unsecured and secured loans can have their own benefits and drawbacks. On one hand, a secured loan can come with lower interest rates but is that worth the risk of putting your property up for collateral? Or pay higher interest rates so you can avoid putting up any property as collateral?

These are questions only you can answer. However, if you are still unsure why does an unsecured loan have a higher interest rate than a secured loan or how that can affect you, you might want to talk to various lenders to figure out which loan is better suited to your needs. You should ask future potential lenders about the rates of their loans and the interest rates along with the maximum loan amounts for unsecured and secured loans both. Getting more information about which kind of loan you should go for will only help you more in figuring out which loan you want to apply for and which one is better suited for whatever it is you are getting the loan for. This will also help you decide if you even want to go for an unsecured and secured loan.

However, if you decide to wait and not take out any kind of loan at the moment, whether it is an unsecured or secured loan, you can work on your credit in the meantime and build it so that even if you accidentally end up defaulting on any loan, it would not affect you as much as it would if you already have a low credit score.

Nabeel Ahmad

Nabeel Ahmad

Nabeel Ahmad is the founder and editor-in-chief of Insurance Noon. Apart from Insurance Noon, he is a serial entrepreneur, and has founded multiple successful companies in different industries.

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