Secured loans: Definition and how they work

If you find yourself in need of additional finances for planned or unplanned expenses, there are many loan products you could choose from. Understanding how they work can help you make the best choice for your unique situation. For example, a secured loan could be an ideal financing option if you’re concerned about your credit score and interest rate.

Though Rocket Loans^SM doesn’t offer secured loans, we want you to understand all your borrowing options.

What is a secured loan?

A secured loan is backed by collateral, such as a home, car, or other asset. Collateral assures a lender that its investment is secure and that it won’t lose money on a loan.

The collateral you can use to secure a loan includes:

• Real estate
• Automobiles
• Certificates of deposit or savings accounts
• Stocks
• Mutual funds
• Other tangible assets

You can apply for secured loans through banks, credit unions, and 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 about equal to the value of the secured loan.

The lender likely will check your credit score and history to assess your creditworthiness. Since the collateral attached to the loan agreement protects the lender in case you default on your loan, it’s more likely you’ll be approved if you have a slightly lower credit score.

Once you’ve been approved, your lender will place a lien on the collateral asset. That gives the lender a legal right to claim the asset if the borrower defaults. The lien is lifted once the loan is repaid.

If the borrower fails to repay the loan, the lender can claim ownership of the asset and sell it to recoup any losses from making the loan.

Secured loans vs. unsecured loans

While secured loans are backed by collateral, unsecured loans are not. Student loans, credit cards, and unsecured personal loans usually require no collateral. Although unsecured loans typically have higher interest rates, they often give the borrower more freedom and flexibility.

Lenders may approve secured loans only for specific expenditures, such as home improvement loans, debt consolidation loans, or emergency expenses.

At the same time, secured loans offer lower interest rates and fees, larger loan amounts, and longer repayment terms. Unsecured loans offer faster funds availability, no collateral requirement, and more flexibility.

Types of secured loans

While several types of secured loans are available to interested borrowers, some are more popular than others.

Mortgages

Mortgages are among the most common types of secured loans. With a mortgage, the borrower pledges their property as collateral to the lender. The lender can foreclose on the home if they fail to pay their mortgage. Foreclosure is the legal process through which a lender takes ownership of a property after a borrower fails to make required mortgage payments. This typically results in the property being sold to recover the unpaid loan balance.

Secured personal loans

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 types of personal loans are unsecured and don’t require collateral. However, lenders offering secured personal loans will provide borrowers with a lower interest rate because of the collateral involved and its assurance.

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 mortgages, your home can go into foreclosure if you fail to make consistent payments on your home equity loan.

Home equity lines of credit

HELOCs, 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 ones in that the borrower must provide a cash deposit as collateral when applying. If the borrower fails to pay their secured credit card on time, the credit card company can draw money from that cash deposit to cover the deficit.

Auto loans

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 car payments, the lender can repossess the car.

Pros and cons of secured loans

Choosing a secured loan for your funding needs has several potential benefits and drawbacks.

Pros

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 loan payments 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.

• Higher borrowing limits for major purchases
• Longer repayment terms for smaller monthly payments
• Potential to improve credit score with on-time payments

Cons

The biggest risk accompanying a secured loan is that if you fail to consistently make payments according to the schedule 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 your chosen collateral.

• Longer approval process due to collateral evaluation
• Potential for negative equity if collateral value decreases
• May require additional insurance or fees

How to get 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.

1. Decide how much you want to borrow. Based on your budget, determine how much you need to borrow and whether you can afford the loan. Lenders will consider your debt-to-income ratio when reviewing your application, so knowing this in advance can lead to fewer surprises later.
2. 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.
3. 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.
4. 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.
5. 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.

What if you can’t make your payments on a secured loan?

Missing payments on a secured loan puts your collateral at risk. If you’re struggling to make payments, it’s important to act.

• Contact your lender right away: Some lenders offer hardship programs or can restructure your loan with more manageable terms if you reach out before missing payments.
• Ask about forbearance options: Your lender may allow you to temporarily pause or reduce payments during financial hardship.
• Consider refinancing your loan: If your credit is still in good standing, you might qualify for a loan with better terms or a lower interest rate.
• Create a strict budget: Cut nonessential expenses and redirect funds toward your loan payment.

If you've already missed payments, your lender will typically follow a default process that could lead to repossession or foreclosure. For mortgages, this process can take months, but for auto loans, it may move faster. Ultimately, the exact process depends on your state’s laws.

Final thoughts: Secured loans mean borrowing with collateral

Once you consider your financial situation and how you plan to use the money from a loan, it may become clearer whether a secured loan fits your needs. When you use your property or possessions as collateral for a loan, there is a risk of losing it if you default on the loan, but if you can manage the payments it may still make sense for you. In many circumstances, however, 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 start the personal loan process today.