Navigating through the different financial products that may be available to you can be a confusing process for the average person, and the world of personal lines of credit is no exception. One of the key factors of understanding them is learning about the differences between a secured and an unsecured line of credit. Having an understanding of the differences and similarities between the two can have a big impact on your overall financial literacy and may even have a positive effect on your financial well-being in the long run.
In this article we’re going to define both terms and talk about the potential benefits and things to look out for with both of them.
What is a Line of Credit?
Before we dive into the differences and similarities between an unsecured and a secured line of credit, let’s start by defining what a line of credit is in the first place.
A line of credit (LOC) is a loan that comes in the form of revolving credit. What this means is that with a LOC, you’ll be given a specific maximum credit limit (similar to how a credit card works) and you’ll be able to draw money from your available credit. As you pay down your balance, you can continue to borrow money when you need it and as long as you have credit available. The important details of your loan, like your maximum loan amount, your interest rates, and more will generally vary between financial institutions.
Benefits of a Line of Credit
So, why would you need a personal line of credit and how can they help you? Let’s take a look at some of their general benefits.
1. Flexible Draw Amounts
To highlight this point, let’s take a quick look at how another common type of loan works; specifically, installment loans. With an installment loan, you’re given a lump sum of cash that you’ll pay back through a series of fixed scheduled payments over the course of a pre-determined time period and there’s generally a minimum loan amount that a financial institution will offer you.
With a line of credit, you’ll have the freedom to request a certain amount of money as long as it’s within your credit limit and you have the available credit, but you can draw as much or as little as you need. You can use it on whatever your particular needs are, and you’ll only be paying interest and/or fees on the amount you draw, not on your total credit limit.
2. It can Act as a Financial Safety Net
When you run into an emergency expense, your first line of defense should typically be your emergency fund. But if you don’t have one or if it won’t cover the entire expense, being able to tap into an emergency line of credit can be an effective way of bridging the gap between this emergency and your next paycheck.
3. Flexible Repayment
Don’t mistake the title of this section to mean that you can pay off your loan with whatever amount you want and whenever you want with no consequences for missed payments, because that’s certainly not the case. But as long as you’re meeting your minimum payments by the deadline, you may be able to make adjustments to how much you’re paying based on what you can afford to pay down beyond your minimum payment.
For example, if you have the money to pay off the entirety of your balance in one go, then go for it. In fact, we encourage you to pay off as much as you can (and as soon as you can) to avoid building up more interest or paying any other extra charges. But if money is tight and you don’t think you can pay off your line of credit all at once, you can keep up with your minimum payments and make additional contributions with any extra money you can spare in each payment cycle.
What is a Secured Line of Credit?
The idea of a line of credit being “secured” or “unsecured” specifically refers to what it takes to get qualified for that particular loan. In the case of a secured line of credit, you’ll need to pledge an asset as collateral in order to qualify. If you can’t pay back what you’ve borrowed, the financial institution will seize control of the asset you’ve put up as a payment of your debt.
Sometimes, the item you’re looking to buy will serve as the asset you’re putting up to secure your loan. This can be the case when you’re looking to buy a house or a car. Depending on the type of loan or line of credit, you can also put up things like stocks or personal items as collateral.
Generally, a secured line of credit or loan is a common way for people to borrow big sums of money. If you need to borrow a large amount of money, a financial institution is going to need a tangible and a substantial promise that you’re going to be able to pay back what you’ve borrowed, and putting your home or car up as collateral is a good way of ensuring that you’re prepared to keep this promise.
Benefits of a Secured Line of Credit
You should have a better idea of what a secured line of credit is, but it may not be completely clear as to what their potential benefits are. Let’s take a look at a couple of them.
1. Helps you with Large Purchases
Like we mentioned earlier, secured loans are often necessary when you’re trying to make a big purchase. The difference between a secured line of credit and certain other types of secured loans is that a LOC may offer you more flexibility.
For example, if you’re looking to do some substantial renovations on your house but you don’t know what the exact cost will be, something like a home equity line of credit (HELOC) can give you the flexibility you need to get the project done without borrowing more money than you actually need. In the case of a HELOC, the collateral you’re putting up is equity in your home.
2. Relatively Lower Interest Rates
When you’re prepared to give a financial institution a valuable asset in case you default, the risk for the institution is generally lower than it would be otherwise. Because of this, secured lines of credit may have lower interest rates than their unsecured counterparts.
What is an Unsecured Line of Credit?
You may have guessed it already, but the main defining feature of an unsecured line of credit is that unlike secured LOCs, the financial institution issuing the loan won’t ask you to put up collateral. Instead, you’ll have to show the issuer that you’ll be able to repay the loan through other means.
Requirements will vary between financial institutions, but your credit score often plays a big role in determining your creditworthiness. This three-digit number summarizes your history as a borrower and is meant to give financial institutions a better sense of your ability to repay your loan. But if you have poor credit, that doesn’t necessarily mean you’re out of options. There are still loans out there that may be available for people with bad credit. Requirements for these loans will vary between financial institutions, but some common qualifications may be things like:
- a regular source of income;
- an active bank account; and
- valid contact information.
Keep in mind that because you’re not providing an asset as collateral, the financial institution is taking a bigger risk by lending to you. This usually results in higher interest rates and/or fees and limited loan amounts.
Benefits of an Unsecured Line of Credit
Just like secured loans, there are some distinct benefits to unsecured lines of credit. Let’s take a look at some of these now.
1. No Risk to Your Assets
While rates may be higher, you won’t be putting any of your assets at risk with an unsecured loan. So, if you don’t need the large loan amounts that sometimes come with secured loans and don’t want to put a major asset at risk, an unsecured line of credit may be an option for your needs.
2. Fast Application Process
Because the financial institution doesn’t need to assess the collateral you’ve provided or transfer titles, and because unsecured loans typically come in smaller amounts, the application process is often relatively quick. For example, through CreditFresh, you can request an unsecured Line of Credit in minutes and if approved, you may receive your money as soon as the same business day3. This is important in situations where you’re facing an emergency expense and don’t have the funds to cover it.
Assess What’s Right for Your Needs
Navigating through the world of lines of credit can be tricky if you’re not armed with the right information. There are all sorts of different products with various nuances that make them unique. But if you educate yourself, they can end up being a very useful financial tool depending on your specific situation.
When it comes to unsecured and secured lines of credit, both have their advantages and specific uses. You’ll have to assess each product and see how they align with your needs and current financial standing.
If you’re facing an emergency expense and don’t have an emergency fund at the ready, an unsecured personal line of credit may act as a financial safety net in times of need. To learn more, visit CreditFresh and learn about how this product works.