Secured vs. Unsecured Lines of Credit: An Overview
A line of credit (LOC) is an open-ended loan that can be used for any purpose. It is a revolving loan, similar to a credit card. That is, the customer can tap the line of credit repeatedly and pay the money back repeatedly. It has a maximum limit but no set expiration date. Lines of credit can be secured or unsecured, and there are significant differences between the two.
- A secured line of credit is guaranteed by an asset, such as a home or a car.
- An unsecured line of credit is not guaranteed by an asset, such as a credit card.
- Unsecured credit always comes with higher interest rates.
Secured Line of Credit
When any loan is secured, the financial institution 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 new car loan. The bank agrees to loan the money while obtaining collateral in the form of the home or the car.
Both secured and unsecured lines of credit can be used flexibly and repeatedly, with low minimum payments and no demands to pay in full. But secured credit is easier to get and cheaper.
Similarly, a business or individual can obtain a secured line of credit using assets as collateral. If the borrower defaults on the loan, the collateral can be seized and sold by the bank 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.
Unsecured Line of Credit
The lending institution assumes greater risk in granting an unsecured line of credit. None of the borrower's assets are subject to seizure upon default.
Not surprisingly, unsecured lines of credit are tougher to get for both businesses and individuals. For example, a business may want to open a line of credit in order to finance its expansion. 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 in compensation.
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.
The secured line of credit is clearly the better option if at all possible, as it keeps the costs of borrowing to a minimum.