What Are Secured Loans and How Do They Work?

Highlights:

• Secured loans require either physical or financial assets to back the loan. As a result, they generally reduce the overall risk to the lender in the event of a default.
• Because they require collateral to back the loan, secured loans may be more accessible to higher-risk borrowers with poor credit scores or little to no credit history.
• Secured loans include mortgages, auto loans, home equity loans, home equity lines of credit, secured personal loans and secured credit cards, among other types of loans.

Whether you're preparing to move into your dream home or buying a new car, many of life's largest purchases rely on a common source of financing: secured loans.

What is a secured loan?

A secured loan is a type of credit that requires some form of collateral to insure the loan. Collateral refers to any valuable asset, either physical or financial, that backs your loan. Lender requirements vary, but homes and other types of real estate, cars, art, cash and investments are all common forms of collateral.

In the event of a default, your lender may be able to seize your loan's collateral to recover some of their investment. In this way, secured loans generally reduce the overall risk to your lender. Secured loans often have more relaxed application requirements and lower interest rates than unsecured options.

How does a secured loan work?

When you take out a secured loan, you allow the lender to assert a legal claim to the asset you put up as collateral. This claim is called a lien. If you pay the loan in full, the lien is removed and your legal ownership of the asset is restored. However, if you can't keep up with payments and your loan goes into default, your lender has the right to seize your collateral through various legal means.

For example, a mortgage is a secured loan that uses your home as collateral. Once you fall behind on your mortgage for a significant period — generally between 30 and 90 days without payment — your loan goes into default. If you don't catch up on your payments, your lender may initiate a legal process called foreclosure. If this happens, the lender can confiscate your home and sell it at auction to recoup any lost funds.

Types of secured loans

There are many types of secured loans, each with its own unique terms and purpose. The most common examples include:

• Mortgages. Mortgages are long-term loans with relatively low interest rates used to purchase a house or other real estate. They usually require you to put up your property as collateral.
• Auto loans. Auto loans are used to finance the purchase of a new or previously owned car, usually using the vehicle itself as collateral.
• Home equity loans and home equity lines of credit. These secured loans use your home's equity (the difference between your home's market value and the amount you owe on your mortgage) as collateral and can be taken out alongside your primary mortgage. A home equity line of credit is a type of revolving credit that can be tapped as needed, while a home equity loan delivers a lump sum of money that you'll pay back over time in fixed installments.
• Secured credit cards. Unlike most credit cards, secured credit cards require a small cash deposit, usually equal to your account's credit limit. These cards generally pose less risk for the lender than unsecured credit cards, which means they typically come with lower qualification requirements. As a result, they may be a good alternative for borrowers with lower credit scores or little to no credit history.
• Business loans. These loans are taken out by companies to cover business expenses and may be secured by company assets.
• Secured personal loans. These loans can be used at the borrower's discretion for anything from large purchases to debt consolidation and more. Secured personal loans and secure debt consolidation loans typically have diverse collateral requirements that vary from lender to lender.

Pros and cons of secured loans

Secured loans can help you reach major financial milestones, but, like all loans, they also come with a certain level of risk. Consider both the pros and cons before you apply for a secured loan.

Pros

• More flexible credit requirements. Loans backed by collateral are generally less risky for lenders than unsecured financing. As a result, it may be easier to qualify for a secured loan than an unsecured loan based on your credit scores, credit history and other financial details.
   
• Lower interest rates. Secured loans generally have lower interest rates than other types of credit as interest rates are also influenced by your credit scores and other factors.
   
• Higher borrowing limits. Secured loans tend to be available in much higher amounts than unsecured loans. For instance, lenders are typically comfortable issuing mortgages totaling hundreds of thousands of dollars because your loan is secured by the value of your home.

Cons

• High borrower risk. Secured loans are much riskier for borrowers than for lenders. If you fall behind on your payments and your loan defaults, your lender has the right to seize the high-value asset used as collateral to back the loan.
   
• Potential to damage credit scores. Like all other forms of credit, secured loans can damage your credit scores and your credit history if you fail to repay what you borrow. When you take out a secured loan, it's important to pay what you owe while monitoring your credit reports and credit scores carefully for any negative changes.

Remember, secured loans can help you achieve some of your most ambitious financial dreams, but they aren't without their risks. To get the most out of a secured loan, you'll need to establish healthy financial habits and stick to them throughout the repayment process.