Understanding secured and unsecured loans and interest rates

A new car. College. A baby! Your first home. Life is full of changes, ups and downs and milestones. At nearly every turn, you’ll need to make tough choices. And those decisions usually involve dollars.

During key points in your life, you may need to take out a loan to help pay for expenses. A loan provides you with money to pay for events or purchases, like a new car, a dream vacation or a college education. You then pay back the amount over time.

You'll probably also pay a certain amount of interest. Interest is a fee you pay to borrow the money. It's usually a percentage of the loan added on top of what you already owe.¹ As for how much interest you'll pay, there are different interest rates for different types of loans. More on that soon.

So far, so good. The tricky part of looking for a loan comes when you start searching for types of consumer loans. You're bound to find long lists and confusing terms like "secured" and "unsecured" (which are not referring to how you feel right now).

As you learn about loans, getting to know key phrases and terms can help you find the right type for you.

Some loans will ask for collateral, so it’s important to know what that means. Collateral is property or another item that you use to back up the loan.² For example, a house is typically the collateral attached to a mortgage. If for some reason a borrower can’t make the payments to repay the loan, the lender has the option to take the collateral.

Before you take out a loan, check the interest rate. There are two common types of interest rates on loans. These are fixed rates and variable rates. Here's what these two terms mean:

• Fixed-rate loans: If you hear about a loan with a fixed rate, it means the interest rate won’t change.³ This can make it easier to calculate what you’ll pay for the loan over time.
• Variable-rate loans: A variable rate means the rate can change.⁴ This could mean that your payments will increase or decrease over time. If the payments decrease, this could be a benefit because you’ll pay less overall for the loan. Variable rates are tied to other interest rates and often include a cap or limit that the interest rate won't go above.⁵

An unsecured loan has no collateral. You simply agree to pay back the loan. For this reason, an unsecured loan might have higher interest rates than other loans.⁶ There may also be some additional fees to pay.

For an unsecured loan, a bank or another lender will first want to know more about you, so they can decide how much is reasonable to lend. They'll usually check your credit to see how you’ve handled money in the past, including if you typically paid your bills on time and if you borrowed money in the past. Based on your credit and the lender’s requirements, the bank or company can then tell you if you can borrow money and how much.⁶

After you receive the loan, you’ll need to pay back the money, along with any interest or fees that go along with it.

Here’s a list of common types of unsecured loans:

• Personal loan: Many personal loans are unsecured. It's your decision how to use the funds. Many people use personal loans to consolidate debt, pay for vacations, weddings, home renovations or to start a small business. Before you take out a personal loan, you may want to look at how much you'll need to pay each month in installments. This can help you decide if the amount can fit into your budget before applying for one.
• Student loan: There are a wide variety of student loans available to help pay for school. They can come from a variety of sources, including the federal government, state agencies, schools and private lenders. Federal student loans usually have more benefits than private loans.⁷
• Credit card: While you may not typically think of a credit card as a loan, it really is a common type. Most credit cards come with a limit (a certain amount that you can borrow up to before you will be unable to borrow more).

When you take out a secured loan, you use an asset as collateral such as your home or car.

Because they are secured with collateral, many secured loans offer lower interest rates than unsecured loans. There are several common types of secured loans:

• Mortgage: This is a loan that can be used to pay for your home where the home itself is the collateral.
• Car loan: When you buy a car and are unable to pay for it up front, you can take out a loan to help cover the cost.
• Home equity loan: This is a loan that you take out to cover certain expenses, like home repairs or renovation.⁸ You use the equity (the part of your home that you actually own) as collateral for the loan.
• Home equity line of credit: This is similar to a home equity loan. You’ll use your home as collateral for the loan. The "line of credit" part, however, refers to the funds available to you. You might be able to borrow some money, and then some more later.⁹ This flexibility can be convenient. If you are redoing a room, for instance, and don’t know exactly what you’ll spend, a line of credit might be useful. You can take out what you need. Then, if you end up spending more, you’ll have more money available through the line of credit.

When life's changes come (and they will), preparation is usually your best friend. Knowing loan basics now can help you make decisions when you reach those turning points. By looking at the interest rates, all the types of loans and the collateral involved, you'll be able to take the next steps on your journey through life. Happy trails.