Secured Loans: How They Work and How to Avoid Default

Sometimes, for whatever reason, you just need money — maybe it’s to buy a car, maybe it’s to make repairs on your home. Whatever the reason, there are many different types of loans to help you obtain funds, but they each come with different advantages and disadvantages.

One type of loan that’s out there is a secured loan, which can be ideal for some people — but not others. But what exactly is a secured loan? Read on, because that’s what we’ll explore in this article below.

What Is a Secured Loan and How Does It Work?

A secured loan is a type of loan that requires you to put up an asset as collateral (which is why it’s also known as a collateral loan).That means the lender can seize this particular asset — which can include a car, a home, business equipment and much more — if you default on the loan.

Because of the collateral involved, a secured loan improves your odds of getting approved if you have a low credit rating or a limited credit history. A secured loan can also be a good choice if you need funds but want to avoid the high interest rates that often come with credit cards or personal loans.

Here’s an example of a secured loan: say someone wants to borrow $20,000 to pay for home renovations. The problem is, he has poor credit, which means he can’t get an unsecured personal loan. However, our hypothetical person owns a $30,000 car that has been fully paid off.

He could likely obtain a secured loan using the car's title as collateral, which would get him the money he needs. However, if he fails to make payments on his loan, the lender can repossess and sell the vehicle to recoup the loan amount.

Examples of Collateral

Lenders accept several types of collateral in exchange for a secured loan. Here are some — but not all — of the things they accept:

• Bank accounts
• Vehicles
• Certificate of deposit accounts
• Investments
• Insurance policies
• Real estate
• Valuable collectibles (art, antiques, coins or stamps)
• Jewelry
• Business equipment or inventory

Six Common Types of Secured Loans

Underneath the category of secured loans, there are distinct types of loans that can be used for different purposes. These types of loans include:

1. Mortgage Loans

A mortgage loan qualifies as a secured loan because the home you are purchasing serves as your collateral. So the stakes for these types of loans are high — if you don’t maintain your payments, the lender can foreclose on your home.

2. Home Equity Loans and HELOCs

A home equity loan and a home equity line of credit (or HELOC) may sound similar, but there are critical differences between them. Essentially, a home equity loan provides a lump sum amount that you borrow against the equity in your home, while a home equity line of credit serves as a revolving credit line secured against your home’s equity that you can draw from as needed.

One critical similarity: your home is your collateral when you take out either of these types of loans, which means it’s especially important to maintain good standing and avoid defaulting in both cases.

3. Auto Loans

When you take out a loan to purchase a vehicle, the car itself serves as collateral for the loan. In other words, if you fail to make the required loan payments, the lender can repossess the vehicle to satisfy the debt.

4. 401(k) Loans

Some lenders allow you to borrow against the balance in your 401(k) account by using the retirement funds as collateral for a loan. So if you fail to repay the loan, the outstanding balance is considered a distribution from the 401(k). This is a dangerous option because it puts your retirement savings at risk if you are unable to pay back the loan.

5. Secured Credit Cards

A secured credit card requires you to put down a security deposit that essentially functions as the credit limit on the account. For example, say you open a secured credit card and put down a $500 refundable security deposit. This amount is now your credit limit, and you can use the secured card just like a regular credit card, making purchases up to the $500 limit — as long as you pay the minimum amount due each month.

By making payments on time, this can help you improve your credit rating and, eventually, possibly upgrade to a regular unsecured card.

6. Business Loan

A secured business loan requires you to put up collateral from your business — such as real estate, equipment or inventory — to guarantee repayment of the loan. As with other secured loans, though, the risks are high — if you don’t pay back the loan according to the agreement, you can lose these valuable business assets.

Secured Loans Vs. Unsecured Loans

Unlike with a secured loan, an unsecured loan doesn’t require you to put down collateral to obtain the funds. When you take out a secured loan, you are required to put down collateral that is at least as valuable as they loan amount. For a secured loan, you are not required to put down any collateral.

Because unsecured loans carry more risk for the lender, they generally have higher interest rates and stricter credit requirements compared to secured loans.

Benefits And Drawbacks of Secured Loans

As with many things, taking out a secured loan has both pluses and minuses. They’re spelled out below:

How to Apply for a Secured Loan

Applying for a secured loan, like many things in the financial world, can be complicated. Here are some of the steps you’ll need to take to apply for secured loan, whether it be at a credit union, bank or another type of financial institution.

1. Determine the value of your collateral asset. It’s critical that you know the value of your collateral when you begin the process, so you should look into getting an appraisal or valuation for what you’re putting down to obtain the loan.
2. Gather all required financial documents. Lenders typically ask for tax returns, pay stubs, bank statements and other critical documents in order to assess your overall financial situation.
3. Check your credit score. Obtain your latest credit score and reports so you have a good sense of your financial standing.
4. Compare lenders. Do your due diligence to find the best fit in regards to interest rates, fees, terms and other criteria.
5. Review your paperwork. Be sure to read your contract before you sign it to avoid unpleasant surprises down the road.

What to Do If You Default on a Secured Loan

Frankly, defaulting on a secured loan is a big deal. On the low end of consequences, you can be assessed a late payment fee that could affect your credit report. Late fees stay on your credit report for up to 7 years, and they can both impact your credit score and serve as a red flag to potential lenders down the road. The larger consequences likely entail losing the collateral that you initially put down to secure the loan, which can lead to you losing your car or even your home.

In order to avoid default — or to move forward if you do default — consider these steps:

• Create a budget. Finances shouldn’t just be left to chance, which is why it’s critical to establish a thorough budget. Defaulting on a secured loan can have devastating effects, and setting up an extensive budget can help you stay on-top of your finances and avoid this unwanted outcome.
• Reach out to the lender. If you are in danger of defaulting on your loan, contact the lender to explore other repayment options. Lenders may be willing to work with you by temporarily modifying the loan terms, extending the repayment period or setting up a revised payment plan.
• Pursue credit counseling. If your ability to pay off your secured loan is looking tenuous, you should strongly consider credit counseling. A credit expert can often negotiate with a lender to help you obtain favorable repayment terms, help you create a debt management plan and can help you devise strategies for managing your finances.

Secured Loan FAQs

Given the complexity of taking out a secured loan, it’s only natural to have questions. Here are some of the more common questions we often see.

How hard is it to get a secured loan?

Secured loans tend to be easier to qualify for than other types of loans because they operate on an easy-to-understand, quid pro quo arrangement. You get the money you need, and the lender has access to something that covers their risk — in other words, collateral. If you pay off your loan, then you keep your asset, the lender gets their money back and everyone wins.

What credit score do I need for a secured loan?

Lenders don’t typically have a credit score etched in stone when they are evaluating offering a secured loan. That said, the higher your credit score, the better your chances of getting a loan. (A higher credit score also means you’ll have a lower interest rate, which just emphasizes the importance of maintaining a good credit rating.)

Will a secured loan hurt my credit?

Having good credit is a key part of modern life. Taking out a secured loan won’t adversely affect your credit rating — that is, as long as you make your payments on time. If you are late with your payments, you could see a negative impact on your credit rating.

Is it a good idea to get a secured loan?

A secured loan can be a blessing for some people, often those who have a lower credit rating. But taking out a secured loan can be risky, as you can lose your collateral if you default — which could be devastating if you’ve put up your car or home to back the loan. So it’s critical to closely examine your situation and ensure you have the financial wherewithal to pay off your loan in a timely manner.

What are some alternatives to a secured loan?

If you don’t want to take out a secured loan, you can consider a personal loan from a credit union or online lender that accepts lower credit scores, or you could take a cash advance from your credit card. (Be mindful that these tend to have very high interest rates.)

Can I get a secured loan with bad credit?

Because of the presence of collateral in secured loan arrangements, they are often good options for people who have lower credit or a limited credit history. But while you may be able to get approved for a secured loan with bad credit, the loan amount, interest rate and terms will likely be less favorable compared to what's offered to borrowers who have good credit.

The Bottom Line

Secured loans aren’t for everybody, but they do offer a way to obtain funds if you, say, don’t have the best credit rating. Regardless, one thing that’s critical is having a good sense of your finances. So download the Rocket Money℠ app today, which can help you monitor your credit score and track your spending to see how a secured loan fits into your budget.