A secured loan is a type of loan that’s backed by collateral, or assets you own. When you take out a secured loan, you’re putting your collateral on the line. If you can’t repay the loan, the lender can take your collateral to recoup their loss.
Because loans secured by collateral reduce the lender’s risk, they allow borrowers to finance large purchases, such as a new home or vehicle. In addition, secured personal loans can be a flexible borrowing option with some advantages, such as lower interest rates. But secured loans also have downsides, and it’s important to understand how they work and the risks they expose you to before you borrow. Here’s what to know before you take out a secured loan.
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Understanding Secured Loans
Loans—whether they’re personal loans or business loans—can be secured or unsecured. With an unsecured loan, no collateral of any kind is required to obtain it. Instead, the lender allows you to borrow based on the strength of your credit score and financial history.
Secured loans, on the other hand, require collateral to borrow. In some cases, the collateral for a secured loan may be the asset you’re using the money to purchase. If you’re getting a mortgage for a home, for example, the loan is secured by the property you’re buying. The same would be true with a car loan.
If you default on the loan, meaning you stop making payments, the lender can seize the collateral that was used to secure the loan. So with a mortgage loan, for instance, the lender could initiate a foreclosure proceeding. The home would be auctioned off and the proceeds used to repay what was owed on the defaulted mortgage.
How Does a Secured Loan Work?
A secured loan is a type of debt backed by collateral, such as physical assets like your house or car, or financial assets such as stocks and bonds. Secured loans are commonly used for large purchases. For example, if you use a mortgage to buy a home or an auto loan to buy a car, the loan is secured by the asset you purchased with it.
There are also secured personal loans, which work like unsecured personal loans but require you to back the loan with collateral. These types of loans can offer lower rates and easier approval, especially for borrowers with low credit.
If you have trouble paying the loan, the lender can put a lien on the secured loan’s collateral. In the event that a borrower defaults on a secured loan, the lender can seize the collateral used to secure the loan. They can then sell it to cover any losses incurred on the loan. In the case of mortgages, this is called foreclosure.
Because the financial and personal consequences of defaulting on a secured loan are serious, it’s imperative to understand what’s at stake before you apply for a secured loan.
Pros and cons of secured loans
Secured loans offer many advantages, but they also have some risks.
Pros
- Easier qualifying standards. You can get a secured loan with lower credit scores or less income.
- Larger borrowing limits. You may qualify for a larger loan amount with a secured loan versus unsecured loans.
- Lower average rates. Lenders typically offer lower rates for secured loans than unsecured ones.
Cons
- Risk of losing your asset. Lenders can collect on an unpaid secured loan by seizing the asset you offered as collateral.
- Your asset must qualify for the loan. Secured lenders will assess the value of your home, car or other asset to determine whether it’s worth enough to support the loan you apply for.
- More paperwork and longer funding turn time. The secured loan process may require more documentation and take longer to fund than unsecured loans.
Secured loan vs. unsecured loan
If you’re trying to decide between a secured versus an unsecured loan, it’s helpful to understand how each works. Choosing one or the other often comes down to how much you need to borrow, what you need the money for, how quickly you need it and whether you meet the qualifying requirements.
Secured loan benefits
- Lower rates and fees. You’ll typically find lower rates on secured loans because they are less risky than unsecured loans. For bad credit borrowers, unsecured personal loan rates can be as high as 36 percent.
- You can borrow more. Because secured loans are tied to the value of the asset you put up as collateral, lenders often allow you to borrow larger loan amounts. Unsecured lenders typically limit loan amounts to $50,000 or less.
- Longer repayment terms are available. With a secured mortgage loan, you can spread your payment out for as long as 30 years. Terms are usually limited to one to seven years with an unsecured loan.
Unsecured loan benefits
- Funds are available faster. Unsecured loans can be funded in as little as one business day after approval, making it a good choice if you need funds quickly. Some secured loans, like mortgages, can take up to six weeks to fund.
- No collateral is required. If you prefer not to risk losing your car, home or other asset due to default, an unsecured loan is a better option. However, there are still consequences for defaulting on an unsecured loan.
- More flexibility for use of funds. Unsecured personal loan funds can be used for just about any legal purpose, from debt consolidation to emergencies. There’s no collateral to approve, so the funds are yours to use as needed.
How to choose between a secured loan and an unsecured loan
| A secured loan is best if: | An unsecured loan is best if: |
|---|---|
| You want lower rates or a lower payment spread over a longer time period. | You need funds quickly with a simple approval process. |
| You’re not in a rush to get funds. | You don’t have an asset to secure the loan with. |
| You’re buying a home, car or other major purchase and need to borrow a large amount of money. | You don’t want to touch the equity in your home or prefer not to borrow against an asset. |
Secured Loans Types
There is a wide range of borrowing options available under secured loans, each tailored to specific needs and financial situations. These secured loan types offer flexibility to individuals to access financing while minimizing risks for investors. For instance, a home loan is a type of secured loan, which can only be used for constructing and buying a new home. The loan amount cannot be used for any other purpose, which reduces the risks of wrong usage of funds.
Following are the different types of secured loans:
Loan Against Mutual Fund
If you need funds, instead of selling your mutual fund units, you can get a loan against them. You can pledge your mutual funds holdings as collateral with the bank or NBFC for a loan. The amount of loan you can get against your mutual funds depends on the mutual fund type and scheme.
As the value of mutual funds changes every day and is market-linked, lenders generally offer lower loan-to-value (LTV) on loans against mutual funds. For instance, banks like HDFC Bank and ICICI Bank offer up to 50% of the NAV as a loan in case of equity mutual funds. And, the LTV ratio goes up to 80% in the case of debt mutual funds. However, not all banks offer loans against mutual funds facilities to borrowers.
The one advantage of taking a loan against mutual funds compared to selling them is you continue to earn returns on the pledged mutual fund holdings.
Loan Against Securities
Loans against securities are offered when you pledge your shares, mutual fund units, or life insurance policies as collateral to the bank or NBFC. A loan against securities is typically offered as an overdraft facility, where you pay interest only on the amount you use.
For example, the bank offers you a Rs 2 lakh loan by pledging your securities worth around Rs 4 lakh. You draw only Rs 1 lakh from your loan account and repay the amount within six months. Here, you will pay interest only on the amount drawn, i.e., Rs 1 lakh for six months, not on the entire sanctioned loan amount.
Vehicle Loans
As the name suggests, this loan is available to purchase two-wheeler or four-wheeler vehicles for personal use. Lenders generally offer up to 90% of the value of the vehicle’s on-road price as loan amount. Until you repay the loan amount, the bank keeps the title of the car as collateral during the loan tenure.
The maximum loan repayment tenure offered on car loans is 84 months or 7 years, while on a two-wheeler, it is 60 months or 2 years.
To be eligible for the vehicle loan amount, you must show the minimum net monthly income (which differs across vehicle class) and a good credit score.
Home Loan
Purchasing a house is a dream for many of us, but you need to make a heavy investment to buy a house. But with a home loan, buying a house for yourself is easier. As the name suggests, a home loan is given to purchase a house or flat, purchase a plot to construct a house, make home improvements, or make home repairs or renovations.
A home loan allows you to buy a house in EMI instead of paying the full price of the house all at once. Here, you can borrow most of the money you need—around 80% of the house’s total cost and repay it over the desired loan tenure. These loans are generally offered for longer tenure, like 15-30 years. In this loan, your house is treated as collateral against the loan; hence, these loans are offered at lower interest rates.
Also, the lender will own the house until you’ve fully paid off the loan. When considering a home, it is essential to plan your budget wisely. You can use the Home Loan EMI calculator to calculate your EMI amount and plan accordingly.
Share-secured or Savings-secured Loans
A share-secured or savings-secured loan is a type of personal loan that is secured using the balance in your savings account.
When you avail of savings-secured loans, the bank freezes the amount in your savings account, you would like to borrow. Compared to unsecured personal loans, savings-secured loans have a lower interest rate and can be extremely useful in rebuilding your credit score.
Secured Credit Cards
A secured credit card is a type of credit card in which you must deposit some money in a fixed deposit in the bank as collateral before receiving the credit card. The spending limit on the credit card depends on the amount you have deposited in the fixed deposit.
This type of credit card is appropriate for applicants with poor credit or who do not have a steady source of income.
Secured Lines of Credit
A line of credit is an arrangement with your bank, where you can borrow at any time against the sanctioned limit. The borrower can repay the amount as per their cash flows and convenience within the agreed terms and conditions. As the money is repaid, the borrower can again borrow from that line of credit. It’s like a revolving credit system.
In the secured line of credit, the borrower maintains an immovable property as collateral with the bank to secure the line of credit to get favorable terms on the loan agreement and lower interest rates. In case, the borrower fails to repay the loan, the bank will sell the immovable property to recover the loan amount.
Car Title Loans
A car title loan is a type of short-term loan where the borrower uses their car as collateral to avail of the loan amount. It allows you to borrow up to 25 to 50% of the value of the car as a loan.
The lender places the lien on the borrower’s car title and the title is returned when the borrower repays the loan amount with due interest.
One of the biggest advantages of title loans is they don’t affect the credit score of the borrower and are the quickest way to avail of a loan.
Life Insurance Loans
The loan amount availed by pledging your life insurance policy as collateral is called a life insurance loan. It is offered only against whole-life insurance policies and money-back policies, where there is a cash value component at maturity. You cannot borrow against the term life policy as there is no maturity benefit involved.
Banks or NBFCs, generally offer no more than 90% of the policy’s cash value as a loan to the borrower.
Bad Credit Loan
A bad credit loan is typically designed for borrowers with low or no credit score. Lenders generally avoid offering loans to borrowers with low credit scores, since there is a high risk of defaulting on the repayments.
An individual must provide collateral such as gold, financial assets, and property to avail of the bad credit loan. Compared to other types of secured loans, the interest rate on bad credit is significantly higher.
Gold Loan
Gold loan is another popular type of secured loan in which you can borrow money in exchange for your gold jewellery or ornaments. You can get this loan from financial institutions such as a bank or a non-banking financial company (NBFC). It is generally given for shorter tenure, such as 6 months or 12 months, and can be extended further if required.
A gold loan is specifically granted against the value of your physical gold. Hence, unlike a home loan, other requirements, such as credit check, income proof, etc., are not required. The maximum loan amount depends on the gold offered as collateral value. Typically, you can get up to 75% of the market value of your gold jewellery. Since gold is kept as collateral, these loans are generally given at lower interest rates as compared to unsecured loans. If you fail to repay the loan, the lender can sell the gold to recover the outstanding amount.
Mortgage Loan
Mortgage loans can be availed by providing immovable assets like residential property, and commercial property as collateral to the lender. The lender keeps the assets until you repay the loan. For example, a loan against property (LAP) can be classified as a mortgage loan.
A mortgage loan can be used for any purpose like to finance your child’s education, wedding, starting a business, cover medical bills, and so on.
What Happens if You Default on a Secured Loan?
The consequences of defaulting on a secured loan depend on how far you fall behind on your payments and on the specific terms of the secured loan you’ve borrowed. In general, missing a payment on your debt can result in lender-assessed late fees. Being at least 30 days late on a payment can result in a late payment showing on your credit report and damaging your credit score.
If you stop making payments on the loan altogether, the lender can seize your collateral. In most instances, the lender’s repossession of collateral assets can remain on a borrower’s credit report for up to seven years.
What sort of grace period you have between missing a payment and losing your asset depends on the terms of your loan contract. That’s why it’s imperative that you review the loan’s terms before you apply, in addition to ensuring you can afford to repay the loan on time.
How to Avoid Default on a Secured Loan
If you’re struggling to afford payments on your secured loan, act quickly to avoid missing payments. Here’s how to avoid default if you start having trouble repaying your loan:
- Review your budget. The first step you should take if you’re struggling to repay debt is to do a deep dive into your budget. Tally up your income and then review your basic expenses to determine the root of the cash flow problem.
- Reduce expenses. If your basic living expenses are putting you in the red, you’ll need to find a way to reduce your cost of living, such as by lowering your bills. If your basic living expenses leave you with enough income to get by, then reducing your discretionary spending may be enough to free up funds and manage your debt. Cutting back can be a challenge, but make avoiding default your priority.
- Increase your income. If possible, look for ways to increase your income such as through taking on extra shifts or a side gig. Flexible work such as driving for a ride-hailing service or offering babysitting and pet sitting through an app may allow you to bring in spare cash around your current schedule.
- Contact your lender. Communication is key if you’re at risk of falling behind on a secure loan payment. Make sure you reach out to your lender as soon as you realize you’ll have a hard time making payments. They may be willing to offer you forbearance or offer another way to avoid the consequences of default.
- Seek credit counseling. If you’re struggling to afford your debts, reach out to a nonprofit credit counselor. Credit counselors can help you review your finances and come up with a plan that works for you. They may help you manage your debt by budgeting, and in some cases, they may suggest a debt management plan.
Secured Loans Features
- Collateral Requirements: The loans are secured and backed by the collateral provided by the borrower. In secured loans, the loan amount should not exceed the value of collateral as it serves as a security for the lender in case the borrower defaults on repayment. There is no need for a guarantor on a secured loan.Â
- Lower interest rate: As loans are backed by collateral and carry less risk of loss for the lender, the interest rate offered on such loans is low compared to the unsecured loans.Â
- Higher Loan Amount: Secured loans can help you to get a higher loan amount based on the value of the collateral.Â
- Structured Repayment Terms:Â Secured loans come with a structured repayment plan, which includes the tenure of the loan, monthly payment amount, and interest rate.Â
- Ownership Retention: The borrower retains the ownership of the property during the loan tenure. Only the title documents of the property are kept by the bank without transferring the ownership.
Secured Loans Benefits
- Lower interest rate: Banks and NBFCs provide lower interest rates on secured loans as they are sure that their money is protected by the collateral given by the borrower.Â
- Higher loan amount: The borrower gets access to a higher loan amount depending on the value of the collateral. The bank or NBFC will approve the loan amount close to the value of the collateral.Â
- Tax Benefits:Â In many secured loan types like home loans, tax benefits are offered on interest payment and principal repayment.Â
- Better Terms & Conditions: Borrowers usually get better terms & conditions on secured loans, cheaper processing fees, and faster documentation and approval process.Â
- Minimum Income Required is Far Lesser: Because secured loans have a longer repayment tenure than unsecured loans, the EMI amount is spread out over a longer period, lowering the EMI amount. This reduces the minimum income amount required to be eligible for secured loans.Â
How to Prevent Default in a Secured Loan
Avoiding a default on a secured loan is very important to protect your collateral and credit score. The following are the steps you can take to prevent a default on a secured loan:
- Assess Your Financial Situation:Â Before applying for a secured loan, evaluate your financial situation. Check if you can commit a part of your income for loan repayment for a longer duration along with your other financial obligations.Â
- Borrow Wisely:Â Banks and NBFCs will always encourage you to borrow the maximum amount possible against the collateral provided. However, you should only borrow the amount you can afford to repay.Â
- Choose the Right Loan Tenure:Â Select the loan tenure that aligns with your financial goals and ability to repay. A long tenure will ensure a lower EMI amount that reduces the chances of default. But, having a longer tenure will result in higher interest costs.Â
- Communicate with Your Lender:Â If you are facing challenges in servicing your loan, you should contact your lender immediately. You can either ask your lender for a moratorium on EMI payments or modify the loan repayment schedule.Â
- Build an Emergency Fund:Â Always have an emergency fund that covers your expenses for at least six months. Having an emergency fund reduces financial strain and gives you time to plan your finances.
Why are secured loans offered in the market?
For lenders, secured loans open up multiple opportunities and grow their business. The following are ways it benefits lenders.
- Helps them to give out larger loan amounts at lower risks.
- Allows them to offer loans at competitive rates and attractive terms to creditworthy borrowers.
- Offer diverse financing options to customers like home loans, car loans, mortgage loan.
- Help in building long-term relationships with the customers which may help in driving more business.
- Stability and predictability in earnings as they can forecast their cash flows and manage them effectively.
For borrowers, secured loans offer many advantages, making them a helpful financial tool for individuals and businesses. Here’s how secured loans benefit borrowers:
- Can borrow higher loan amounts at lower interest rates.
- Improves the approval odds as the loan amount is secured by the collateral.
- Longer repayment tenure resulting in lower EMI amount.
- Predictable monthly payments of EMI.
- Allows borrowers to use the assets for various purposes without giving up the ownership.
Do Secured Loans Have Lower Interest Rates?
Most secured loans do have lower interest rates than unsecured loans. However, there are exceptions—pawn loans and bad credit loans can have very high interest rates, as can title loans. Read the fine print carefully before signing an agreement.
What Happens if I Default on my Secured Loan?
If you miss a payment or default on your secured loan, the lender can seize whatever you used as collateral. That item, whether it’s your car, house, or personal property, can then be sold to recoup the loan amount.
Applying for a secured loan
The process of applying for a secured loan will vary depending on what type of secured loan you need. Mortgage loans are the most involved, requiring a deeper dive into your employment history, assets, credit history and the value of the home you’re buying or refinancing.
Car, boat and RV loans require less paperwork, and can often be approved relatively quickly. Secured personal loans work similarly to vehicle loans and require that you prove the value and ownership history of the asset you’re using as collateral for the loan. There are typically five steps involved in applying for a secured loan.
- Know your credit score. Regardless of the loan type the lowest rates, longest terms and highest loan amounts typically go to high credit score borrowers. Knowing your score ahead of time will help you avoid surprises when you start getting loan offers.
- Get an estimate of your collateral’s value. Lenders offer secured loans based on the value of the asset you are putting up. You should check with a real estate agent for a home’s value, scan Kelley Blue Book values for a car or find out where you can get reliable information about your asset’s value.
- Shop at least three lenders. You should check with your local bank or credit union to see if they offer any discounts as a current customer. Alternatively, online lenders may compete for your business if you use an online comparison tool.
- Provide financial documents. Have pay stubs, W-2s, bank statements, employment and address information handy. You’ll need to provide them to the lender to finalize your secured loan for closing.
- Close your secured loan. Check the final numbers before you close to make sure the interest rate, closing fees and payment are what you expected. If you get a secured loan with bad credit, make sure you understand the default timelines if you need to catch up on payments.
The bottom line
Secured loans is that they offer lower interest rates, higher borrowing limits, and easier approval compared to unsecured loans, due to the collateral involved. This makes them suitable for large purchases like homes or vehicles. However, they carry the risk of losing your collateral if you default on payments. It’s crucial to carefully consider your financial situation and repayment ability before opting for a secured loan to ensure you can manage it responsibly and avoid potential consequences of default.