Borrowing against your assets can lower your interest rate. But there are risks too
August 17, 2022 – By Kat Tretina
If you have less-than-stellar credit, you may find that qualifying for a loan is tricky. Opting for a secured loan—where some form of your assets or property act as collateral—may make it easier to get a loan.
Lenders are more likely to approve you for a secured loan than an unsecured one because they can take the collateral if you fail to make your scheduled payments. They can sell your collateral to get their money back, making the loan less risky. And the idea of losing your valuables can motivate you to make all of your payments on time.
It’s important to understand the benefits and drawbacks of secured loans and only take out a loan if you’re sure you can repay it.
“If you know you can’t pay it back on time, or if you’re even questioning if you can, a secured loan is probably a bad idea,” says Madison Block, senior marketing communications associate with American Consumer Credit Counseling, a non-profit credit counseling agency.
Here’s what you should know before taking out a secured loan.
What is a secured loan?
Secured loans require some form of asset as collateral, such as a car or house. There are several forms of secured loans, but the most common are mortgages, car loans and secured personal loans:
- Mortgage: When you took out a mortgage to buy a house, your new home secured the loan. If you don’t make your payments, the lender can start foreclosure proceedings.
- Car loan: Car loans are secured by the vehicle you purchase. If you don’t make the payments as scheduled, the lender can repossess your vehicle.
- Secured personal loan: You can use a secured personal loan to cover an emergency expense, home improvement project, medical bills, to consolidate debt or for other expenses that pop up. They are usually secured by an asset, such as cash in a savings or brokerage account, insurance or a vehicle or real estate (that you already own) and the lender can take if you miss the payments.
In the cases of mortgages and auto loans, secured loans are used by people of all credit levels, while secured personal loans are often favored by people with lower credit scores that may not get approved for an unsecured loan.
Secured vs. unsecured loan: What’s the difference?
When you take out a loan, it can be secured or unsecured. Lenders that offer unsecured loans decide whether to approve you for a loan—and what interest rate to give you—entirely based on your credit history and income. If you miss your payments on an unsecured loan, the lender can send it to collections, report the late payments to the credit bureaus and charge late fees.
With secured loans, the lender has some security in the form of your property. This feature can help borrowers qualify for loans that otherwise wouldn’t be eligible, says Bruce McClary, senior vice president with the National Foundation for Credit Counseling, a non-profit credit counseling agency.
“The lender faces less risk in the event of loan default since they can sell the collateral to recover some of the outstanding balance,” he says.
With a secured loan, the consequence of defaulting on your loan is that the lender can take and sell your items to recover the money they loaned to you.
What credit score is needed for a secured loan?
According to Equifax, one of the major credit bureaus, FICO credit scores—the most commonly used scores—range from 300 to 850. The higher your score, the better.
Unsecured loans typically require good to excellent credit, meaning a score of 670 or higher. By contrast, secured loans have much lower credit score minimums. Depending on the lender, you may be able to qualify for a loan with a score as low as 560, according to commonly advertised rates, which is in the poor credit range.
Poor credit means you may have missed several payment due dates in the past or that you may frequently max out your credit card spending limit. Or you may have declared bankruptcy in the past; bankruptcies stay on your credit report for years and damage your credit.
What happens if you default on a secured loan?
While secured loans can be appealing if you’ve struggled to find a lender willing to work with you in the past, they can be risky.
When you take out a secured personal loan, the lender puts a lien on your collateral, meaning the lender has a legal claim on your property. In the case of a mortgage or car loan, the lien is voluntary—you agree to the lien as part of the loan agreement.
If you make all of the agreed payments on time, that lien isn’t a problem. Once the loan is paid in full, the lien is removed and you own the property free and clear.
But if you default on the loan, the lender can exercise its right as a lienholder and repossess your car or foreclose on your home when you default without having to take you to court.
With some lenders, you may be able to request forbearance and pause your payments if you’re dealing with a financial emergency. Interest will still grow on your loan, but you’ll have a few months where you don’t have to make payments. However, not all lenders offer this option, so you may be in default as soon as you fail to make a scheduled payment.
How quickly the lender can take action and put a lien on your property is dependent on your location, state laws and the loan type:
- Mortgages: While the timeline for default varies by lender, mortgages are usually considered to be in default once your payment is 30 days late. However, the lender cannot begin foreclosure proceedings until your payment is more than 120 days delinquent.
- Car loans: With car loans, the rules can vary by state. In general, lenders can repossess your car as soon as you default on your loan.
- Secured personal loans: How quickly a lender will take your collateral varies by the lender, the state you live in, the type of collateral you have and the terms of your contract. In some cases, the lender will hold onto your property for a few days or weeks to give you a chance to pay what you owe.
Also, remember that defaulting on a secured loan can further damage your credit. A single late payment can cause your score to drop by a significant amount. Miss a payment by 30 days and your credit could decrease by 60 points or more. If you’re late for 90 days or more, your score could drop by over 100 points.
How to apply for a secured loan
While the application process is slightly different for each type of secured loan, the basics are the same.
Typically, you can fill out an application for a secured loan online or in person at a local bank or credit union. The lender will ask for your personal information, including:
- Your Social Security number
- Mailing address
- Employer contact information
- Proof of income, such as pay stubs, W-2 forms or tax returns
Even though the loan is secured, the lender will still ask for your consent for a hard credit check, allowing it to your credit reports from one of the major credit bureaus—Experian, Equifax or TransUnion—which can affect your credit. For most people, hard credit inquiries decrease their scores by fewer than five points.
The lender will also ask for information about your collateral, such as its age and condition. With secured loans that use property as collateral—such as a car loan or mortgage—the lender will require an appraisal to determine its value. The maximum amount you can borrow is based on the collateral’s appraised value.
The appraisal process varies based on the item you’re using as collateral and the lender. In some cases—such as personal loans secured by a car—you can submit photos of your item and input its make, model and year and get an instant valuation. But with other forms of property, like high-end jewelry, the lender may require an in-person appraisal from a trained professional.
Rates and terms can vary by lender, so shop around and compare quotes from multiple companies.
Alternatives to secured loans
Although there are advantages to secured loans—and in the case of buying a car or house, they’re often a necessity—taking out a secured loan isn’t always wise, says McClary.
If you’re already having financial difficulties, taking out a secured loan doesn’t solve the problem, and may make it worse. “That’s a sign that you should get help addressing your financial challenges before borrowing more money, McClary says.”
Depending on your circumstances, one of these alternatives may be a better choice for you:
Consider a credit card
If you’re thinking about using a secured loan to consolidate high-interest debt, another option is to apply for a balance transfer credit card. Many credit card companies offer cards with annual percentage rates, or APRs, that are low for the length of the card’s promotional period—usually six to 18 months. With some cards, the APR is 0%, so you don’t have to worry about interest charges during the card’s promotional offer. After the promotional period ends, the card’s regular APR applies.
You tend to need fair to good credit to qualify for a balance transfer card, however, so they aren’t an option for everyone. For people with poor credit, a standard credit card is another way to get the money you need, but it may have a higher APR than a secured personal loan.
Add a co-signer to your application
If you’re applying for an unsecured loan and don’t meet the lender’s credit or income requirements, you may be able to qualify for a loan if you add a co-signer that has good to excellent credit and a stable source of income to your application.
A co-signer—usually a relative or friend—is obligated to repay the loan if you miss your payments, so adding a co-signer decreases the risk to the lender. With a co-signer, you’re more likely to get approved. And you may secure a lower interest rate than you’d get on your own.
Asking someone to co-sign a loan is a huge request and should be done warily, says Ronald Colvin, a certified financial planner in Reno, Nev. “A good co-signer is someone who is both willing and easily able to pay if the original borrower can’t fulfill their obligation,” he adds. “If the co-signer can easily absorb the financial hit, it’s less of a problem.”
Apply for a payday loan
If you need cash fast, a payday loan can sound like a lifesaver. They’re short-term loans for relatively small amounts—usually $500 or less—and you repay the loan when you receive your next paycheck.
However, payday loans’ astronomical rates of interest—often as high as 400% APR—mean they should be a last resort because lenders charge astronomical fees, says Thomas Henske, a certified financial planner in New York. “People who need a payday loan…don’t have any other options,” he says.
Wait and save
If you intend to use a secured loan for a non-essential expense, such as a vacation or home renovation project, think about postponing the expense until you’ve saved enough money to cover the cost upfront. While this approach takes longer than applying for a loan, you don’t have to worry about interest charges or losing your collateral.
You can use budgeting tools to manage your money and identify areas in your budget to trim, and high-yield savings accounts can help you meet your goal faster. You can also sell unused items like books, electronics, clothing or sports equipment to get the money you need quickly.
Sign up for credit counseling
If you feel overwhelmed by debt or aren’t sure how to get your finances in order, contact a non-profit credit counseling agency. A certified credit counselor will review your finances with you and help you create a plan for solving your money issues. During credit counseling sessions, you can get help creating a budget, paying down debt and reviewing your credit reports.
You can search the U.S. Department of Justice database of credit counseling agencies to find a reputable credit counseling agency near you.