What's the difference between a secured or unsecured loan?
Whether we like it or not, it seems that more of us are turning to personal loans as a way of financing more costly purchases, from cars to conservatories.
In fact, the Bank of England recently revealed [PDF] that the growth of consumer credit was 9.3% in the year leading to February 2016, the highest it'd been since December 2005.
Yet as widely available as credit is at the moment, there still remains the question of which of the two main kinds of personal loan someone in need of an extra lump of cash should take out.
As such, this guide will offer a rundown of secured and unsecured loans, explaining when the customer might need one or the other, and going over the benefits and risks of each.
Put simply, secured loans are those that use the debtor's house as a guarantee. In the event that he or she can't repay the loan, the lender will force the sale of this house, receiving the proceeds of the sale, minus what's still owed to the mortgage lender.
Because they use mortgages as collateral, secured loans can't be taken out by people who rent their own homes.
However, they offer many advantages to those homeowners who need them, since the 'security' of the home means lenders are willing to give more money at better rates.
For instance, they can be as high as £150,000, whereas unsecured loans generally rise only as high as £25,000 (although some rare exceptions, such as Sainsbury's £35,000 unsecured loan, go higher).
Added to this, they can be repaid over a much longer length of time, with the maximum duration sometimes being as long as 20 years.
This means that, while the interest rate is often lower on secured loans, the total amount of interest paid over the course of the loan is considerably higher than that for an unsecured loan.
In other words, they're more expensive in absolute terms, yet cheaper insofar as the monthly repayments make up a smaller percentage of the total loan.
For example, a secured loan of £50,000 with a typical APR of 5% could be repaid in the following ways:
|Duration||Monthly repayment||Total repayable||Cost of interest|
As the table shows, longer loans demand smaller monthly repayments, but mean you end up paying more over the duration of the loan.
Still, even if longer loans do result in bigger total interest costs, secured loans can be an ideal solution for those who happen to have a lower credit rating and therefore can't obtain an unsecured loan.
That said, they should generally be regarded as a last resort for financing larger purchases, since they may result in home repossession if the person taking them out fails to keep up with repayments.
Also, it's generally not a good idea to use them for debt consolidation. This is because, in using a secured loan to pay off money owed on credit cards and unsecured loans, the borrower will be paying considerably more interest on such debts in the long term.
Added to this, he or she will effectively be transforming unsecured into secured debt. Because of this, what were once unsecured loans will now risk home repossession in the event that the borrower still can't manage to repay them.
This is why, if you have a good enough credit record, and you need only a relatively small amount, an unsecured loan is the better option.
Even though they're called "unsecured" loans, they're more secure for the person taking them out, since they don't carry the risk of home repossession.
Yet it's for this reason that they don't provide as much credit, and that they can't be repaid over a longer period of time.
As mentioned above, customers generally can't obtain more than £25,000 with an unsecured loan, while at the same time the maximum duration of repayment is in the region of five years.
This may not be great, yet it's worth pointing out that, due to fierce competition between lenders, interest rates for unsecured loans can be as low as 3.3%, although such a rate is likely to last only for as long as the Bank of England keeps a low base rate.
Also, such competitive interest rates are normally available only for those borrowing within the £7,500 and £15,000 range. Any higher or lower, and the borrower's APR could easily pass the 10% mark.
Nonetheless, assuming an APR of 4%, an unsecured loan of £8,000 could be repaid over the following timescales:
|Duration||Monthly repayment||Total repayable||Cost of interest|
The first thing this table makes apparent is that unsecured loans can be markedly cheaper than secured loans, if only because a smaller amount of money is involved.
However, two things need to be highlighted. Firstly, the most competitive unsecured loans are awarded only to about 10% of applicants, underlining that you really need a solid credit rating to be eligible for one.
Secondly, even though an unsecured loan isn't backed by the borrower's home, failure to repay can still have serious repercussions.
Not only would such failure seriously damage a customer's credit score, but the lender may choose to go to court to get their money back.
In some cases, this could result in the court issuing a charging order, which essentially converts the loan into a secured one. Even worse, the lender could in extreme circumstances obtain an order of sale, which forces the sale of the borrower's property so that the lender can recoup what they're owed.
Pros and cons
This, however, is the worst-case scenario. So long as people take out an unsecured loan knowing just how they're going to budget for it, then there's little chance of them being taken to court or having their property forcibly sold.
And the same can be said for secured loans, in that few lenders if any want to actually go through the laborious process of legal action. They simply want to have the loan repaid, since this is more profitable for them than going before a judge.
This is not to say that either kind of loan can be taken lightly. However, it is to say that both ultimately work to the interests of the borrower in most circumstances.
And while the question of which kind of personal loan to take out varies depending on the borrower's particular circumstances, a few basic distinctions can serve to close this guide.
Secured loans are ideal for homeowners with poorer credit looking to receive a larger loan, while unsecured loans are ideal for those with good credit who want a smaller sum that can be repaid in a shorter amount of time.
|Secured loans||Unsecured loans|