Secured Loans: A Definition And How They Work
Hanna Kielar5-Minute Read
December 23, 2022
Loans can provide a much-needed lifeline for people looking to buy a house, finance a new car or renovate their home. If you’re thinking of taking out a loan, it’s important to be aware of the various types of loans available and how some might be better suited to your situation than others. For example, a secured loan could be an ideal financing option if you’re concerned about your credit score and interest rate.
Let’s explore secured loans and some instances in which this type of loan could be the best option for you.
What Is A Secured Loan?
A secured loan is a loan that’s backed by collateral such as a home, car or other valuable asset owned by the borrower. Collateral can help assure a lender that their investment is worthwhile and that the money the borrower owes them will successfully be paid back over the course of the loan term.
Collateral you can use to secure a loan includes:
- Real estate properties
- Certificates of deposit (CDs) or savings accounts
- Mutual funds
- Other tangible assets
How Does A Secured Loan Work?
You can apply for secured loans through financial institutions like banks and credit unions, as well as online lenders.
Before approving you for a secured loan, your lender will need to verify that the value of the collateral asset you’re offering is approximately equal to the value of the secured loan.
The lender will also likely need to run a check on your credit score and history to assess your creditworthiness. Since the collateral attached to the loan agreement provides an added layer of protection for the lender and incentivizes the borrower to stay on top of their payments, lenders of secured loans may be more likely to approve borrowers with a slightly lower credit score.
Once you’ve been approved for your secured loan and have determined what you’ll be using as your collateral, your lender will likely place a lien on the collateral assets – giving the lender ownership rights over the assets – until the loan is fully repaid, at which point collateral ownership will transfer back to the borrower.
If the borrower fails to repay the loan, the assets can be liquidated, sold or repossessed to cover the remaining expense.
Secured Loans Vs. Unsecured Loans
While secured loans are backed by some kind of collateral, unsecured loans – like student loans, credit cards and unsecured personal loans – aren’t. Although unsecured loans can have higher interest rates, these loans often give the borrower more freedom and flexibility in how they can spend their funds.
Types Of Secured Loans
While several types of secured loans are available to interested borrowers, some are more popular than others. Let’s take a look at a few of these options next.
Mortgages are one of the most common types of secured loans. With a mortgage loan, the borrower puts up their mortgaged property as collateral for the lender, and if they fail to make their mortgage payments, the lender can claim the home through the foreclosure process.
Secured Personal Loans
Secured personal loans can be used for various reasons.
Unlike a mortgage, a personal loan’s repayment term is usually only 12 – 60 months, with typical loan amounts of $1,000 – $50,000. An approved borrower receives this loan in a lump sum and immediately begins making monthly payments.
Most personal loans are unsecured and don’t require collateral. However, lenders who offer secured personal loans will provide borrowers with a lower interest rate because of the collateral involved and the assurance that it offers.
Home Equity Loans
Another common type of secured loan is the home equity loan. Like a mortgage, a home equity loan uses the borrower’s home as collateral for the lender. Home equity loans can be a good option if, like with a personal loan, you need access to a large sum of money all at once. You should also have substantial equity in your home when considering this type of loan.
However, as with mortgage loans, your home can go into foreclosure if you fail to make consistent payments on your home equity loan.
Home Equity Lines Of Credit
Home equity lines of credit (HELOCs) are lines of credit that, like home equity loans, are secured by the borrower’s equity in their home. This type of loan can be used for almost anything within reason, and you can repeatedly use the line and pay off the balance as needed over your loan’s lifetime.
Secured Credit Cards
Secured credit cards differ slightly from traditional credit cards in that the borrower must provide a cash deposit as collateral when they apply. If the borrower fails to pay off their secured credit card on time, the credit card company can draw money from that cash deposit to cover the deficit on the bill.
Just as you might expect, funds for auto loans are secured by the lender using the vehicle itself as collateral. If the borrower fails to make their car payments, the lender can repossess the car.
Pros And Cons Of Secured Loans
Choosing a secured loan for your funding needs comes with several potential benefits and drawbacks.
A secured loan can be a great option for those who possess assets that can serve as collateral, and who feel confident in their ability to consistently make payments on their loan to avoid losing those assets.
This type of loan typically offers a lower interest rate and looser credit requirements. Getting approved for a secured loan can be easier than getting approved for an unsecured loan, since your collateral provides additional protections for the lender.
The biggest risk accompanying a secured loan is this: If you fail to consistently make payments according to the schedule laid out in the terms of your loan’s promissory note, you can lose the valuable collateral asset or assets you used to back the loan.
Secured loans are also more limited than unsecured loan types like personal loans and credit cards, in that the money tends to be approved for specific purposes connected to the collateral of your choosing.
How To Prepare For A Secured Loan
As with any loan application process, you’ll benefit from setting aside some time to prepare before applying. Take the following steps to ensure your success in acquiring a secured loan.
- Determine your desired loan amount. Figure out how much you need to borrow and if you can afford that amount based on your personal budget. Lenders will consider your debt-to-income ratio (DTI) when reviewing your application, so knowing this in advance can lead to fewer surprises down the line.
- Check your credit report. Check your credit report to make sure your credit is healthy enough to qualify for a loan. Knowing your credit score can also help you determine if you even need a secured loan or can qualify for an unsecured one.
- Estimate your collateral’s value. You’ll want an estimation or appraisal of the asset you’re offering as collateral to determine its approximate value compared to your desired loan amount.
- Shop lenders. Once you start looking for lenders, get prequalified with a few of your prospects to see the deals you may qualify for. Rates and terms can vary between lenders, and you’ll want to make sure you choose the one offering the best deal.
- Submit your application. Fill out and submit an application to the lenders you believe are the best fit. If approved, you’ll receive your funds in your account and begin the repayment process shortly thereafter.
Whether a secured loan is the best fit for your needs largely depends on how you plan to use the money and your financial situation. Being required to put up collateral to appease your lender is no small ask, and in many instances, applying for an unsecured personal loan and avoiding the need for collateral altogether will be in the borrower’s best financial interest for the long term.
Ready to explore your financing options? Talk with a Loan Expert and get the personal loan process started today with Rocket Loans℠.
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