More people are taking out personal loans lately вЂ“ whether to consolidate debt, make a large purchase, or pay for some other important transaction. The rise may be due, in part, to increased access to personal loans via online lending. The U.S. Federal Reserve puts it this way: вЂњToday, thanks in no small part to the marketing efforts of fintech firms, consumers recognize online lending as a convenient, fast, and simple way to obtain a loan.вЂќ 1
Although current loan-application processes are streamlined, thereвЂ™s still homework to do before applying for a personal loan. What can you do to improve your chance of qualifying? How can you get the most favorable terms? One thing that can make a big difference is whether you choose a secured personal loan or an unsecured personal loan.
Types of Personal Loans: Secured and Unsecured
Personal loans are all-purpose loans from banks, credit unions, and fintechs that you pay back in regular monthly installments. They are usually categorized separately from more specific loan types, such as mortgages or student loans.
Personal loans represent the fastest-growing debt category in the U.S., according to the Experian credit reporting agency. Overall, personal loan balances grew 12% year-over-year in the second quarter of 2019 to $305 billion. 2 ExperianвЂ™s research also shows people taking out larger personal loans in recent years. Personal loans with balances of $30,000 or more increased 15% between 2014 and 2019, while balances of $20,000 to $25,000 rose 10%.
- Secured. A secured personal loan requires you to commit assets like your home or savings as collateral against non-payment. If you end up unable to make your loan payments, your assets could be seized and resold by the lender to recoup its funds.
- Unsecured. An unsecured personal loan relies on your credit history to mitigate the lenderвЂ™s risk. If you canвЂ™t pay, a lenderвЂ™s recourse would be to send a collection agency for the funds or to sue you, both of which could also damage your credit rating.
Most personal loans are unsecured. BorrowersвЂ™ choices between the two often hinge on their credit score and available assets. For someone with a poor credit score, putting up collateral might help qualify for a loan they otherwise would not get. But you can only qualify for a secured loan if you have sufficient assets. Besides your home or savings, including investments and certificates of deposit (CDs), those assets could include your car or future paychecks вЂ“ not to be confused with payday loans. 3
Secured and Unsecured Personal Loan Interest Rates
Secured personal loans are less risky for lenders, so they usually have lower interest rates and are easier to get approved вЂ“ including for higher amounts and longer terms. Unsecured personal loans put borrowers at less risk, since their home, car, or other valuables are not at stake.
Interest rates and lengths of personal loans vary significantly. One online guide to personal loans published a range of interest rates from about 6% to 36%, over time periods of one to seven years. 4 Secured personal loans tend to come in at the lower end of the interest rate scale. In , the Federal Reserve reported a 9.34% average interest rate on 24-month personal loans, whether secured or not. 5
I checked out the website of one federal credit union (FCU) and found that it generally offered personal loans from 7.99% APR for two years to % APR for six years, up to a maximum of $50,000. In comparison, an FCU customer holding a share certificate вЂ“ similar to a CD вЂ“ could take out a secured personal loan for up to 75% of the certificateвЂ™s value, at less than 6% APR. 6,7
Credit Score Affects Secured vs Unsecured Loan Choice
Your credit score is likely to play an important role in your choice between a secured or unsecured loan. A borrower with a low credit score might be declined for an unsecured personal loan and then turn instead to a secured personal loan, with a greater chance of qualifying. And since secured loans often have higher borrowing limits and longer time horizons, their loan options are more flexible.
Borrowers with an excellent credit score, on the other hand, may see little difference in the terms offered to them by secured or unsecured personal loans. 8
How People Put Personal Loans to Use
ExperianвЂ™s survey of people with at least one personal loan showed that they borrow for a variety of reasons. Multiple responses were allowed, so these sum to more than 100%:
- Large purchases: 28%.
- Debt consolidation: 26%.
- Home improvement: 17%.
- Refinancing existing debt: 9%.
- Other: 30%.
Many Americans have traditionally used a home equity line of credit (HELOC) instead of a secured personal loan for the purposes on this list. HELOCs typically get you lower interest rates because they use your homeвЂ™s equity as collateral. However, a HELOC is very different from a personal loan in that it provides you with access to a line of credit that you can draw from вЂ“ or not вЂ“ over a period of time. According to an analysis by TransUnion, an increasing number of borrowers with above-average credit ratings are opting for unsecured personal loans instead of HELOCs, which is another factor driving personal loansвЂ™ recent payday loans South Dakota high growth. 9
Amid an overall growth spurt in personal loans, consumers have two primary choices: secured personal loans and unsecured personal loans. The choice often comes down to your credit score and available assets. At stake are differences in the ease of access, cost, and terms of the loan you are seeking.