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Loans

Here's the difference between secured and unsecured loans

There are two types of loans: secured and unsecured. CNBC Select breaks down both and explaining the pros and cons of each, and what assets can be used as collateral.

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While some people swear by a cash-only lifestyle, the truth is most of us rely on credit to pay for life's big expenses over time. When you want to buy a big-ticket item like a house or a car, open or grow a business, renovate a kitchen or pay for college, you can apply for a loan at either your local back or online to help you cover the cost.

When considering your credit options, you might have to decide between a secured and unsecured loan. Secured loans require that you offer up something you own of value as collateral in case you can't pay back your loan, whereas unsecured loans allow you borrow the money outright (after the lender considers your financials).

There are pros and cons to both types loans, so before you decide anything it's best to understand the strings attached.

What is a secured loan?

A secured loan is a loan backed by collateral. The most common types of secured loans are mortgages and car loans, and in the case of these loans, the collateral is your home or car. But really, collateral can be any kind of financial asset you own. And if you don't pay back your loan, the bank can seize your collateral as payment. A repossession stays on your credit report for up to seven years.

When you take out a secured loan, the lender puts a lien on the asset you offer up as collateral. Once the loan is paid off, the lender removes the lien, and you own both assets free and clear.

Here are the kinds of assets you can use as collateral for a secured loan, according to Experian:

  • Real estate
  • Bank accounts (checking accounts, savings accounts, CDs and money market accounts)
  • Vehicles (cars, trucks, SUVs, motorcycles, boats, etc.)
  • Stocks, mutual funds or bond investments
  • Insurance policies, including life insurance
  • High-end collectibles and other valuables (precious metals, antiques, etc.)

Secured credit cards, such as the Capital One® Secured Mastercard® and the First Tech® Federal Credit Union Platinum Secured Mastercard®, are another example of a secured loan. The collateral, in this case, is the cash you put down (often a $200 refundable deposit) that acts as your initial credit limit. You get your deposit back when you close the account.

Because your assets can be seized if you don't pay off your secured loan, they are arguably riskier than unsecured loans. You're still paying interest on the loan based on your creditworthiness, and in some cases fees, when you take out a secured loan.

Don't miss: The best secured credit cards of October 2020

What is an unsecured loan?

An unsecured loan requires no collateral, though you are still charged interest and sometimes fees. Student loans, personal loans and credit cards are all example of unsecured loans.

Since there's no collateral, financial institutions give out unsecured loans based in large part on your credit score and history of repaying past debts. For this reason, unsecured loans may have higher interest rates (but not always) than a secured loan.

Unsecured personal loans are growing in popularity. There are roughly 20.2 million personal loan borrowers in the U.S. according to the online lending marketplace Lending Tree. You can take out a personal loan for nearly any purpose, whether that's to renovate your kitchen, pay for a wedding, go on a dream vacation or pay off credit card debt.

Most people get personal loans for debt consolidation, and since personal loans tend to have lower APR than credit cards, borrowers can often save money on interest.

What to know before you take out a loan

Before you take out a personal loan, whether it's secured or unsecured, make sure you have a clear payoff plan.

As a general rule, only borrow what you know you need and can afford to pay back. Make sure you are comfortable with the repayment timeframe. Just because you can get a loan doesn't mean you should, so take your time and do your research before you sign on the dotted line.

Learn more: 10 questions to ask before you take out a personal loan

Information about the Capital One® Secured Mastercard® and the First Tech® Federal Credit Union Platinum Secured Mastercard® has been collected independently by CNBC and has not been reviewed or provided by the issuer prior to publication.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the CNBC Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.