What Is a Secured Loan and How Do They Work?

If you're one of the nearly 30% of Americans with fair or poor credit (a FICO score under 670), qualifying for a loan can be tricky. Opting for a secured loan—where some form of your assets or property acts as collateral—may make it easier to get a loan, or allow you to qualify for a more competitive rate.

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. This makes the loan more risky for you, however. 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, a house or a savings account. If you fail to make payments, the lender can seize and sell your asset to help recoup its losses. There are several forms of secured loans, but the most common are mortgages, car loans and secured personal loans.

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, said Madison Block, a senior marketing communications associate with nonprofit credit counseling agency American Consumer Credit Counseling.

"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," Block said.

How do secured loans work?

Secured loans are typically installment loans, which means you receive the money or the asset upfront and then pay it back with interest over time, often in monthly installments. For example, if you're approved for a secured personal loan, you'll receive the money in a lump sum and pay it back over a period of years. Terms for secured personal loans typically range from two to seven years.

Some secured loans may have a lengthy closing process. This is because the value of the collateral may need to be appraised. This is not the case with most auto loans, where the collateral has readily-available Kelly Blue Book valuations or retail sticker prices. But home loans (a.k.a. mortgages) require that the home being purchased is appraised by a third-party appraiser, which can add weeks to the closing, along with any issues that arrive from a too-low valuation.

Check Out: Best Personal Loans

Pros and cons of secured loans

Secured vs. unsecured loans: What's the difference?

Lenders that offer unsecured loans decide whether to approve you for a loan—and what interest rate to give you—based largely on your credit history and income. If you miss payments on an unsecured loan, the lender can send it to collections, report the late payments to the credit bureaus and possibly charge late fees.

With secured loans, the lender also 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 nonprofit 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, a consequence of defaulting on your loan is that the lender can take and sell your asset to recover the money it loaned to you (on top of the damage you'd do to your credit report and score).

Types of secured loans

Mortgage

When you take out a mortgage to buy a house, your new home secures the loan. If you don't make your payments, the lender can start foreclosure proceedings. The amount you'll qualify for depends on the value of the home, your income and your credit.

Car loan

Car loans are secured by the vehicle you purchase, and their amounts are similarly influenced by the car's value and your credit profile. If you don't make the payments as scheduled, the lender can repossess your vehicle and report the delinquent account to the credit bureaus.

Secured personal loan

You can use a secured personal loan to cover an emergency expense, home improvement projects, medical bills, to consolidate debt or for many other expenses. They are usually secured by an asset, such as cash in a savings or brokerage account or a vehicle, which the lender can take if you miss the payments.

Secured credit card

Secured credit cards are generally easier to attain than a traditional card because they require an upfront deposit, which acts as collateral on the line of credit. Credit limits are usually equivalent to the deposit, but this can vary.

Home equity loans and lines of credit

Home equity loans and home equity lines of credit (HELOCs) are types of second mortgages, and therefore come with the same risk if you default: foreclosure. But either may allow you to borrow against a portion of the equity you've built up in your home.

Check Out: HELOC vs. Home Equity Loans

Life insurance loans

If you have a permanent life insurance plan, you may be able to borrow against the accumulated cash value. Any amount you don't pay back will be deducted from your plan's death benefit if the loan is outstanding when you die. The policy could also lapse if you don't make sufficient payments on the loan, such that the interest owed outpaces the remaining cash value.

Not to mention, if the policy lapses, you could owe tax on the entire cash value since the IRS could see the loan and interest payments made from the cash value as withdrawals. So it's not a risk-free option.

Business loans

If you own a business, you may be able to pledge collateral to obtain a loan for that business. These work similarly to secured personal loans, but your business's credit score will be on the line if you miss payments, along with the collateral.

Related: Best Personal Loans for the Self-Employed

Secured loans to avoid

Pawn shop and title loans may seem appealing if you've struggled to get approved for other types of credit, but they're incredibly risky and best avoided. The fees associated with these loans, coupled with their typically short terms, can lead to triple-digit APRs and a debilitating cycle of debt.

A 2022 Pew Research study found the average payday loan APR was over 200% in 24 of the 32 states that allow them. A 2016 study by the Consumer Financial Protection Bureau found that one in five title loan borrowers have their vehicles repossessed due to lack of payment.

What credit score is needed for a secured loan?

FICO credit scores—the most commonly used scores—range from 300 to 850. The higher your score, the better your chances of being approved for a loan, and at a competitive rate.

Before you start your loan search, make sure you know where your credit sits by checking out AnnualCreditReport.com for free copies of your reports from Equifax, Experian and TransUnion. It's important to ensure you're using a reputable site, as the Federal Trade Commission has warned of companies offering free reports as a pretense for collecting personal information that could potentially be misused.

What happens if you default on a secured loan?

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. 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.

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 could 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. For example:

• 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, which can be as soon as 30 days after you miss a payment, depending on your lender.
• 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.

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
• Birthday
• 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 require your consent for a hard credit check, allowing it to access 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 typically require an appraisal to determine its value. The maximum amount you can borrow is based in part 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."

Depending on your circumstances, one of these alternatives may be a better choice for you:

Consider a credit card

Best if: You're eligible for a 0% APR offer or a card with a competitive rate

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, that 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. Be sure you check your existing cards for 0% balance transfer offers.

You tend to need fair to good credit to qualify for a new 0% balance transfer card, however, so they aren't an option for everyone. For people with poor credit, a standard credit card may be another way to get the money you need, if you qualify, but it may have a higher APR than a secured personal loan.

Check Out: Best Balance-Transfer Credit Card

Add a co-signer to your application

Best if: You know someone with strong credit willing to guarantee the loan

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. Or, you may secure a lower interest rate than you'd get on your own.

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, making you more likely to be approved.

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."

Look into payday alternative loans

Best if: You're a member of or can join a federal credit union

If you need cash fast, a traditional 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 fees—sometimes amounting to APRs well over 400%—mean they should be a last resort. Instead, consider payday alternative loans. These are offered by certain federal credit unions, and can come in amounts up to $2,000 with repayment terms as long as a year, depending on the type. You'll need to be a member of the credit union to take one out.

Wait and save

Best if: You want to avoid taking on new credit

If you intend to use a secured loan for a nonessential 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

Best if: You feel overwhelmed by debt or aren't sure how to get your finances in order

If you need assistance managing your finances, you may want to contact a nonprofit credit counseling agency. A certified credit counselor can review your finances with you and help you create a plan. 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.

FAQ

Do secured loans have lower interest rates?

Secured loans can have lower rates than unsecured loans, due to the decreased risk on the lender caused by pledging collateral.

What can be used as collateral for a personal loan?

Acceptable collateral varies by lender, but in general examples can include your home or car, investments, and even the fixtures in your home, in some cases. Just remember that whatever you pledge can be taken by the lender if you miss payments.

Where can I get a secured loan?

Secured loans can be found from a variety of sources, including banks, credit unions, and online lenders. Make sure you shop around to find the best option for your situation.

What happens if I default on a secured loan?

If you default on a secured loan, the lender can seize your collateral. Missing payments can also cause your credit score to drop significantly.

How to avoid default on a secured loan

Setting up reminders to pay your loan on time, or even setting up automatic payments, can help you avoid a default. (Some lenders even offer a discount for paying automatically.) When searching for loans, remember that the best loan is generally the one with the lowest rate and a monthly payment you can comfortably afford for the entire life of the loan.

Read More:

• What Are the Requirements for a Personal Loan?
• How Much of a Personal Loan Can I Get?
• How To Get a Personal Loan
• How To Get a $10,000 Loan
• How To Get a $20,000 Loan
• Best Loans for a Bad Credit
• Best No-Credit-History Loans
• Best Emergency Loans