There are two basic types of personal loans: secured and unsecured.
A secured loan is backed by an asset that the lender can seize if you don’t repay the loan. Loans used to buy autos and homes are the most common types of secured loans. The asset you’re buying is the security for the loan, and the bank keeps the title until you pay off the loan.
An unsecured loan is based only on your creditworthiness and ability to repay. Most personal loans are unsecured, and so are most credit cards. There’s no underlying asset for the creditor to seize if you don’t pay. For that reason, interest rates for unsecured loans tend to be higher.
In some cases, you can use an asset you already own as a way to get a secured personal loan. Some lenders may allow you to take a secured personal loan against the value of a car, a savings account or a certificate of deposit. The most common collateral is a car.
Lenders offer lower interest rates on a loan with collateral. Borrowers who might not be approved for an unsecured loan may be able to get one that is secured, or they may be offered a larger loan amount.
Secured vs. unsecured personal loans
The biggest difference between secured and unsecured personal loans is what happens if you stop making payments, or default, on the loan.
A secured loan agreement gives the lender the right to seize the collateral without going to court. You likely would be given a chance to make good on the debt — cure the default — before the lender places a lien against your asset.
An unsecured loan borrower also faces severe consequences for defaulting, but the creditor would have to sue and win a court judgment to collect what you owe it.
In both cases, the late payments will hurt your credit scores.
Some other differences:
Interest rates: The better your credit scores, the lower the rate you’ll be offered on any loan, secured or unsecured. But secured personal loans are less risky for lenders, and the rates are considerably lower.
Credit requirements: A borrower who doesn’t qualify for an unsecured personal loan might qualify for a secured personal loan. But your credit history and ability to repay are always factors.
Availability: Unsecured personal loans are widely available, both online and through banks and credit unions. Secured personal loans are less common.
Using your car to secure a personal loan
Most secured personal loans use an automobile as collateral. The lender takes title to your car until you pay off the loan. But the loans themselves can be very different, depending on your credit score and history and on how much equity you have in your vehicle.
IF YOUR CAR IS PAID OFF
Auto title loans are widely considered predatory, charging interest rates of as much as 260% on an annual basis. These lenders offer 40% or less of your car’s value, but you risk all of the asset. The loan doesn’t depend on traditional credit checks. NerdWallet strongly urges you to avoid these loans, as one in five borrowers wind up losing their vehicle.
Auto equity loans allow borrowers to get a loan against the value of their paid-off vehicle. If you can’t get an unsecured loan, pledging a paid-off car as collateral could allow you to qualify for a secured loan. It might also allow you to get a larger loan amount than with an unsecured loan, and the interest rate could be as much as 10 percentage points lower. Annual percentage rates charged by reputable lenders don’t exceed 36%. Expect the lender to consider your credit scores as well as your ability to repay the loan.
IF YOUR CAR ISN’T PAID OFF
Cash-out auto refinancing is for people who still owe money on the original loan but have built equity in the vehicle. The borrower takes out a new loan for an amount that’s higher than the original one. The new loan pays off the original and gives some cash back to the borrower. The lender considers your credit history and ability to repay. Reputable lenders don’t charge APRs higher than 36%.
Auto loan refinancing lowers the payments on your original loan, giving you more cash in your monthly budget — a good option for borrowers whose credit has improved. You still need to have some equity in the car to qualify.
Using savings or a CD to secure a personal loan
Lenders may offer a loan secured by your savings account or certificate of deposit. However, if you have a savings account or a CD that’s close to maturity, it may be better to use the money you’ve saved up rather than borrowing money and paying interest on it.
The exception is if you’re considering a credit-builder loan to establish your credit history. In that, the lender grants you a loan but withholds the proceeds until you’ve made the payments. Once you’ve paid off the loan, you’ll have a history of on-time payments on your credit record and a savings account with your payments in it, minus interest charges.
Before you consider any personal loan
Whether your loan is secured or unsecured, an APR below 36% should be your goal. That mark is the widely accepted upper limit of affordability.
Before you take out a secured loan, however, consider whether you can afford to lose the asset you’re pledging. You shouldn’t risk the car you use to get to work, for example.
If you’re rejected for both unsecured and secured loans, you may be tempted to turn to predatory lenders that don’t check your credit, such as payday lenders, auto-title lenders and payday installment lenders. But these loans come at a heavy price — the average APR typically is 300% or more on auto title loans and 390% on payday loans.
The risks are overwhelming: The odds of not being able to pay off the loan are high, your credit is trashed if you don’t make the loan payments, and you could get hit with costly bank overdraft fees.
There are better alternatives for fast cash if you really need the money.
Updated Sept. 13, 2016.