Unsecured vs. Secured Personal Loans—How do they Work?

If you're looking to consolidate debt, planning to buy a car, facing an unexpected expense, or even just want to improve your credit score, getting a personal loan can be a smart financial move.

However, there are different kinds of personal loans available, depending on your personal needs, and you'll want to make sure you choose the right loan for your situation. If you're considering taking out a personal loan, here's a brief overview on how personal loans work, the differences between the main types of personal loans, and how to select the right one for you.

What is a personal loan?

A personal loan is money that's borrowed from a bank, credit union or other financial lender and that can be used for a range of different expenses, including medical bills, credit card debt, home repairs, wedding expenses, funeral costs and so on.

This type of loan is considered an installment loan, which means borrowers are expected to repay the total loan amount with regular payments over a fixed period of time. Each payment of an installment loan includes a portion of the principal amount of the loan, as well as a portion of the interest accumulating on the debt. Payments are normally made monthly, but interest rates and schedules can vary.

Although it can often be best to draw from an emergency fund or existing personal saving account to pay for large, unexpected expenses, there are many effective ways to use a personal loan, such as paying off high-interest credit card debt.

There are two primary types of personal loans: secured and unsecured loans. Here's how they work, and when you might use each of them.

How a secured personal loan works

A secured loan is a type of loan in which a borrower puts up a personal asset as collateral, such as a house or a car, or even cash. If the borrower defaults (stops making payments) on a secured loan, the lender can take possession of the collateral to satisfy the debt.

Common examples of secured personal loans include mortgages and auto loans; in most cases, the home or car being financed becomes the collateral for the loan. Because a secured loan involves less risk to the lender, they are often easier for applicants to qualify for, and interest rates are typically lower compared to unsecured loans.

When to choose a secured personal loan

Secured personal loans can be used to borrow money for major purchases with an interest rate that is as low as possible, given your specific financial situation. If you'd like to buy a home, a mortgage loan can help spread the purchase price over the course of 15 or 30 years, making it much easier to afford. If you're looking to finance improvements to your home, a home equity loan is a secured way to borrow money using the equity in your home, giving you access to cash at a generally lower interest rate than an unsecured personal loan or a credit card.

How unsecured personal loans work

An unsecured loan is a type of loan that doesn't require collateral. Instead, lenders will base their decision to lend money to you based on financial factors including your income level and your creditworthiness. Because the risk is typically higher for lenders, interest rates for unsecured loans tend to be higher than for secured loans.

The benefit for you, the borrower, is that, because you don't need a specific piece of collateral to secure the loan, you are able to use the borrowed money for whatever you need, whether that's paying down high-interest credit card debt (called debt consolidation), college tuition, medical expenses or a dream vacation or wedding. And you'll still likely pay a lower interest rate than you would have if you used a credit card.

When to choose an unsecured personal loan

Unsecured personal loans can be used to improve your financial situation, carry you through unplanned expenses or emergencies, or allow you to reach a personal goal without having to wait to save up cash for it. If you have high-interest credit card debt, securing a debt consolidation loan with a low interest rate could help you pay down debt while incurring less interest. If a family member has fallen ill or been seriously injured and you're facing medical bills beyond your emergency savings fund, an unsecured personal loan can give you access to cash when you need it the most. And if you're planning a large purchase or project in the near future—perhaps you need a new refrigerator, are planning your wedding, or taking an overdue vacation—taking out a personal loan can take the pressure off from having to pay for major expenses immediately.