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If you’re looking to borrow money, you’ll find that loans fall into two categories: secured and unsecured loans. And understanding the differences between these two types of loans can help you determine which is best for your situation.
In order to dig into the difference between secured and unsecured loans, and find out how both impact credit, we reached out to Harold Weston, clinical associate professor and undergraduate program advisor at Georgia State University.
Here’s Weston’s interview on the difference between secured and unsecured loans:
Q1: What is the main difference between secured and unsecured loans?
A1: Secured loans have collateral, meaning something of value that can be taken if the lender does not pay. In the case of secured loans, the borrower gives the title of the “property” to the lender. Thus, a house is security for a mortgage, a car is security for a car loan and a boat is security for the boat loan. Sometimes the “security” is not only the title, but actual possession, such as when a lender actually holds stock certificates and bonds and life insurance policies and jewelry.
Unsecured loans don’t require collateral.
So, for example, a credit card is typically an unsecured loan, because there is no collateral for it, only a promise to pay. But some credit cards are secured by money left on deposit with the bank. In addition, a relative or friend might give an unsecured loan, based only on the borrower’s promise to pay.
Q2: Is there any downside to applying for an unsecured loan with a co-applicant?
A2: Yes. Both people who are on the loan are fully responsible to pay it back. It doesn’t matter if one person is supposed to pay it back, and the other person expects only to be a guarantor, or if both applicants expect to pay it together. If one person does not pay, then the other person (the co-applicant) must pay the full amount.
A parent might be a co-applicant for a student taking out a college loan — if the student does not pay, then the parent must pay. Likewise, a married, or unmarried couple, who take out a loan together are both individually liable to pay it back, even if the other partner fails to pay his share.
Are there any benefit to obtaining an unsecured loan? Are there any strict terms to look out for?
The benefit is there is no loss of collateral if you don’t pay. That’s what makes an unsecured loan riskier for the lender, and so usually the interest rate is higher.
Sometimes an unsecured loan is a letter of credit, for either individuals or businesses, based on total assets, or income or financial strength on the balance sheet — or some combination. The lender has confidence in the borrower’s ability to repay and commitment to repay.
Q3: Can you build your credit score with an unsecured loan?
A3: If the lender reports to the credit reporting companies, then the borrower’s payment practices will count for, or against, their credit score. It’s similar to how utilities and telecommunication providers report on the payment history of their customers.
An unsecured loan from a relative or friend will not be reported to a credit reporting bureau. But if you don’t pay them back, then you have a bad “score” among family and friends, and if they sue you and get a court judgment, then the judgment does affect a credit score.
Q4: What advice would you give to anyone seeking a personal loan?
Loans should be used only for major capital purchases — cars, houses and college — and never more than the borrower can realistically pay off. Don’t use a loan for personal living expenses unless you have an emergency. And don’t use a loan for a wedding.
Generally, if you can’t afford to buy something now, then save up until you can afford the thing. If you can’t pay off your credit card when the bill comes in next month, then stop charging so much — charge only as much as you can pay off each month.
We’d like to thank Harold Weston for taking the time to provide some great insight.