What is the difference between a secured loan and an unsecured loan?

What are the key differences between a secured loan and an unsecured loan? Christina Barr, senior solicitor in restructuring and insolvency at Brodies LLP, explains the advantages and disadvantages of secured and unsecured loans.

What are the differences between secured and unsecured loans?

There are many reasons why someone might want additional funding. Whether it’s because of debt problems or simply needing extra funds to make a purchase, loans are commonplace for most people at some point in their lives.

However, before accepting and entering any loan conditions, you should make sure understand the terms of what you are signing and know whether the loan is secured or unsecured, as each has its own consequences.

Fundamentally, a secured loan is backed by some form of collateral, such as property or another asset, while an unsecured loan is not backed by any collateral.

What is a secured loan?

As mentioned, a secured loan is backed by some form of collateral, such as property or another asset –commonly the individual’s home. Due to their nature, secured loans tend to be for larger sums (at least £10,000) and common examples of secured loans include:

a homeowner's loan (usually used for home improvements)
second mortgages
first charge mortgage
car financing
debt consolidation loans

From a lender's perspective, a secured loan provides the least risk exposure to them, which is why it is usually a cheaper way for an individual to borrow money. However, the risk profile for an individual is higher because in the event of default, the lender can enforce its security. If the security is the individual's home, the lender can repossess the property. If an individual already has a mortgage, funds from the sale would be used to repay the mortgage and to pay off the second ranking security.

A secured loan is obviously much riskier for an individual but may be cheaper in the long run as competitive interest rates are likely to be offered, particularly where the collateral offered is similar in value to the loan itself. Though it is important to check whether the interest rate is fixed or variable; if it's variable, payments could increase throughout the lifetime of the loan.

An individual will also need to have a reasonable credit score, otherwise it's unlikely that the application will be accepted by the lender. 'Hidden costs', such as arrangement fees also need to be factored into the overall price of loan. These costs are usually included in the annual percentage rate of charge, but it is always worth checking.

What is an unsecured loan?

An unsecured loan, often known as a 'personal loan', is not backed up by any collateral. Unsecured lending tends to be more straightforward and allows an individual to borrow money from a bank or other lender on an agreed repayment plan until monies are repaid in full. Should the individual default, this usually results in penalty payments.

As there is no collateral over this type of loan, interest rates tend to be higher due to the increase of risk to the lender. Should payment not be received, the lender may raise a court action to obtain judgement against the individual. Thereafter, enforcement may include inhibiting property (if owned), which would mean it could not be sold until payment in full had been made. Additionally, failing to repay an unsecured loan could affect an individual's credit rating, which would have ramifications for accessing further credit and their ability to purchase property.

Factors to consider when taking out a personal loan include:

the interest rate being offered
cost of arrangement fee
annual percentage

These should all be factored into monthly repayments. Personal loans tend to be a quick way to secure a cash injection and are usually cheaper than buying on a credit card that carries an interest rate, although the T&Cs offered by credit card providers can vary enormously with some even offering 0% interest for limited periods.

What type of loan should you get?

The type of loan that may be available to an individual depends on numerous factors, including:

the sum of money involved
whether the individual owns property
credit scores

Interest, annual percentage rate and arrangement fees all vary depending on the lender, so individuals should shop around and speak with a professional to ensure they are obtaining the best deal.

Christina Barr Brodies