Secured vs. Unsecured Lines of Credit: An Overview
A line of credit (LOC) is a revolving loan that can be used for any purpose. The borrower can tap the line of credit at any time, pay it back, and borrow again, up to a maximum limit set by the lender.
Lines of credit can be secured or unsecured, and there are significant differences between the two, such as the interest rate paid by the borrower.
- A secured line of credit is guaranteed by collateral, such as a home.
- An unsecured line of credit is not guaranteed by any asset; one example is a credit card.
- Unsecured credit always comes with higher interest rates because it is riskier for lenders.
What Is a Secured Line of Credit?
When any loan is secured, the lender has established a lien against an asset that belongs to the borrower. This asset becomes collateral, and it can be seized or liquidated by the lender in the event of default. A common example is a home mortgage or a car loan. The bank agrees to loan the money while obtaining collateral in the form of the home or the car.
Similarly, a business or individual can obtain a secured line of credit using assets as collateral. If the borrower defaults on the loan, the bank can seize and sell the collateral to recoup the loss. Because the bank is certain of getting its money back, a secured line of credit typically comes with a higher credit limit and a significantly lower interest rate than an unsecured line of credit does.
Both secured and unsecured lines of credit can have a big impact on your credit score. In general, if you use more than 30% of the borrowing limit, your credit score will drop.
What Is an Unsecured Line of Credit?
A lender assumes greater risk in granting an unsecured line of credit. None of the borrower's assets are subject to seizure upon default. Unsurprisingly, unsecured lines of credit are tougher to get for both businesses and individuals.
A business may want to open a line of credit in order to finance its expansion, for example. The funds are to be repaid out of future business returns. Such loans are only considered if the company is well established and has an excellent reputation. Even then, lenders compensate for the increased risk by limiting the amount that can be borrowed and by charging higher interest rates.
Credit cards are essentially unsecured lines of credit. That's one reason why the interest rates on them are so high. If the cardholder defaults, there's nothing the credit card issuer can seize for compensation.
|Secured Line of Credit vs. Unsecured Line of Credit|
|Secured LOC||Unsecured LOC|
|Guaranteed by collateral||Not guaranteed by an asset|
|Lower interest rates than for unsecured credit||Riskier for lenders, so interest rates are higher|
|If a borrower defaults, lender can seize collateral||More difficult to get approved by lenders|
Should I Choose a Secured or Unsecured Line of Credit?
Whether or not you choose a secured or unsecured line of credit depends in large part on why you are using it. For everyday purchases, an unsecured line of credit such as a credit card may make the most sense.
An unsecured line of credit is usually not your best option if you need to borrow a lot of money. As mentioned earlier, unsecured credit is riskier for lenders and typically comes with higher interest rates. Secured credit, on the other hand, is easier to get and cheaper.
The Bottom Line
Both secured and unsecured lines of credit have advantages over other types of loans. They can be used (or not used) flexibly and repeatedly, with low minimum payments and no demands to pay in full as long as the payments are up to date.