When accessing financing options, a secured loan will always appear at the top of the list. Creditors like banks and other financial institutions prefer secured loans over unsecured loans as there is less risk in this type of lending. However, even though it's the most preferred type of loan for creditors, secured loans can still affect your credit score.
In this article, you'll discover how secured loans can affect your credit score. We will also discuss how secured loans work and how that relates to mortgages. And ultimately, you'll understand better “how does a secured loan affect your credit score?”. But first, let’s quickly understand what is a credit score and why it is important in any loan consideration.
Why Is a Credit Score Important?
When you ask for a simple loan from your close friends or relatives, they may quickly extend financial help to you. That is because they know you as a person and trust you. However, it doesn't work that way for banks or other financial institutions when it comes to extending loans to you. First, these entities don't know you personally. For them, you're a stranger. So if you ask for a loan from them, it's like asking for money from a stranger.
So what do they rely on to decide if they are willing to extend a loan to you? It is through reviewing your credit score. You can think of a credit score as your grades. A higher credit score means that you're creditworthy and a good debtor. Through credit scores, lenders can determine your qualification and eligibility for a loan. Moreover, your score will also highly determine the interest rate levels that creditors will charge you when they give you a loan.
In finance, there's a principle stating that the assumption of higher risks requires a higher return. The more risk an investor takes, the higher the reward expected. So for a loan, the credit score of the borrower is a measure of risk. If your credit score is 600 or below, lenders will have more concerns about your financial situation and your ability to make payments on the loan.
Thus, if they decide to give you a loan, the interest rate will be higher than those with higher creditors.
Let’s next quickly discuss the difference between secured and unsecured loans.
Secured vs. Unsecured Loans
So, what is a secured loan? A secured loan is a contract wherein the creditor agrees to extend financing to the debtor in exchange for security. A security can be a real or personal property of significant value. In other words, the security's value must be equal to or more than the amount of the loan. However, some creditors accept securities below the loan amount provided that it's not significantly deficient.
For example, Harry applied for a loan at ABC Bank. The amount of the loan is $100,000. Harry's credit score is 700. ABC Bank approved the loan in exchange for Harry's house with a fair market value of $200,000. In this case, the loan is a secured loan since Harry's house secures the financial position of ABC Bank. In the event of a payment default, the bank has access to Harry’s house which is worth more than the loan amount, thus minimising any risk to the bank.
On the other hand, an unsecured loan is any loan without security. It is entirely the trust between the creditor and the debtor. For some creditors, this type of loan is riskier since there's no recourse if the debtor fails to pay. However, some risk-seeking lenders see this as an opportunity to charge high-interest rates that are sometimes unconscionable. But many people without a good credit history often have few options other than this type of loan. Remember, the higher the risk, the greater the reward.
How Does Secured Loan Work?
When you apply for a secured loan, you enter into two contracts. First, you sign a contract of loan, the principal contract. Then, since the creditor requires you to secure the loan with assets you own, you enter another contract called a mortgage contract. A mortgage contract depends on the kind of property you put as security.
If it's a house, land, or any immovable property, the contract would be a real estate mortgage contract. If it's a car, yacht, or something moveable, the contract would be a chattel mortgage contract. In other words, you can call these contracts liens or encumbrances on the property. You may also call it “claims against properties.”
Now, suppose you weren't able to pay the debt. What will the creditor do? The creditor will foreclose the mortgage. Meaning, the creditor will now have the right to take property from you and sell it in an auction wherein any proceeds will be used to pay your debt. That's the reason why creditors prefer secured loans because they have a recovery plan in case you default.
Mortgages in Different States
In the United States, every State follows a theory in mortgage. This topic is important because it will help you in deciding if it's beneficial to take a secured loan.
One of the theories in mortgage transactions is the lien theory. This theory dictates that the title to the mortgaged property remains with the borrower. Therefore, borrowers still own the property under this theory. Upon full payment of the loan, the lien is extinguished, and the creditor can no longer assert his right to foreclose the mortgage. In the US, here are the states that use this theory in credit transactions:
- New Mexico
- New York
- North Dakota
- New Jersey
- Puerto Rico
- Rhode Island
- South Carolina
In contrast, other States use the title theory. In this theory, the mortgaged property shall be put under a Deed of Trust and make the lender the beneficiary of the property. Unlike the lien theory, a third party (i.e., trust) holds the property until the borrower pays the loan. Upon full payment, the lender will now issue a Deed of Reconveyance to return the original title to the debtor. States using this theory are the following:
- Washington D.C.
- New Hampshire*
- North Carolina
- South Dakota
- Washington State
- West Virginia
Effect on Credit Score
A secured loan can benefit you or adversely impact on you. It's a double-edged sword. So, how does it benefit you? First, you can get a secured loan to build credit. And if you're an excellent payer, you'll have a higher credit score as time goes by. Moreover, getting secured loans can help develop your credibility as a borrower. In case you need more of these loans in the future, it'll be easier to get one given your credit history.
Now, how can a secured loan have an adverse impact on you? If you fail to make payments on time (e.g., skipping payments, late payments), it will tarnish your credit score. Every time you make a late payment, the bank will report this to the credit bureaus. Aside from that, you might get penalties and charges for late payments.
In case you become financially challenged, the risk of losing your mortgaged property is high. And if it comes to that, the bank will now exercise its right to foreclose the mortgage and use its proceeds to pay off the loan's remaining balance. In effect, you lose your property, and your credit score will go down significantly. And all too often, this is what happens to many people who may have over-committed on the amounts borrowed, overestimated their ability to pay or is simply unfortunate enough to be hit by life’s unforeseen bad circumstances like an illness, accident or a loss of a job
Choosing a Secured Loan: Pros and Cons
A secured loan is one of the best sources of financing. It is an agreement wherein creditors are inclined to extend financing to you because it has a security. While this sounds encouraging, it's still good to know some pros and cons of secured loans.
|Pro #1: Lower Interest Rates|
|Aside from credit score, the existence of a security can affect the amount of interest the creditor will grant to you. Moreover, the value of the mortgaged property also dictates interest rates. For example, you want a loan of $200,000. As security, you presented a 24-carat diamond ring. After appraisal of the ring, its value is estimated to be around $350,000. |
For creditors, that lien is very attractive. If the prime rate is at 3.25 percent, you'd probably receive an interest rate of 4 to 5 percent. In case you're wondering, unsecured loans have interest rates that can go as high as 15 percent.
|Pro #2: Access to Larger Loan Amounts|
|Unsecured personal loans have limits. Sometimes, limits are set at $20,000. However, you can go higher if you can secure the loan with valuable property. Using the example above, the appraised value of the ring is $350,000. If you want a loan of $400,000, most banks will approve that since the value of the ring is not significantly below the loan amount. But if you ask for that kind of amount without security, the bank will automatically reject it.|
|Pro #3: Increased Creditor Confidence|
|When you apply for a secured loan, creditors are not too afraid to release money since there's a security. In the example above, it can be a diamond ring. In a secured loan, creditors will not put too much thought into your loan as long as the security is valuable. But if you give a security with a small value, creditors will renegotiate the loan at an amount that matches the property's value to be mortgaged.|
|Con #1: Possibility of Foreclosure|
|If you don't want to lose your property if you fail to pay the loan, a secured loan is not for you. If you have several properties, perhaps mortgaging one property is not a significant concern. However, even if you intend to always pay on time, the possibility of a financial problem further on is still present. So in deciding, you have to consider your future capability to pay as well.|
|Con #2: Mortgaged Property Must Be of Significant Value|
|You can't just go to a bank and say that you want a secured loan. If you presented an old car as security/collateral, banks will automatically reject your loan since the car is already old and probably has a low fair value. That's why it's also harder to get a secured loan because banks will be particular about the kind of property you present.|
|Con #3: Not Ideal for People With No Property or Credit|
|If this is your first time availing of a loan, you can look at Loan Corp for a start. A secured loan is impossible for you unless you have a property that can be mortgaged. But if you're still building credit and have no property of significant value, a secured loan is probably not available to you. You should first consider smaller loans to build credit.|
A secured loan can be your best option if you need financial help. But whether you are eligible for such a loan or should opt for this would depend on your credit history and financial situation. As we have seen it has both pros and cons which you need to carefully consider before committing to one. If you default on making your payments it can severely affect your credit score and this has major implications for you in many aspects of your life.
Read our guide on how to improve your credit score if you believe having a good score will benefit you significantly.