Understanding Loans and Interest Rates: A Close Look at Secured and Unsecured Loans

Get to know the loan basics

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. The average American owes more than $38,000 (not counting any mortgages).1 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. 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.

What’s collateral?

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, if you take out a car loan, you will usually use the car you buy as collateral.3 If for some reason you can’t make the payments to repay the loan, the lender has the option to take the collateral. This is sort of like insurance for the bank that gave you the loan to make sure they get paid back in one way or another.

Interest rates

Before you take out a loan, check the interest rate. If you take out a loan of $3,000 and the interest rate is set at 10%, you can expect to pay $300 on interest (10% of $3,000) over the life of the loan.

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: If you hear about a loan with a fixed rate, it means the interest rate won’t change. This can make it easier to calculate what you’ll pay for the loan over time.

Variable rate: A variable rate means the rate can change. 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.

Unsecured loans explained

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. 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.

After you receive the loan, you’ll need to pay back the money. This is usually done over a set period, like a number of months.4 You may also have to pay interest and fees.

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

  • Personal loan: Most personal loans are unsecured.5 It's your decision how to use the funds. Many people use personal loans to 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: Some student loans are unsecured.6 When taking out an unsecured student loan, you may be asked for a co-signer. This is someone with a solid credit rating who agrees to sign on to the loan. If you can’t make the payments, the co-signer will pay them for you.

  • Credit card: While you may not typically think of a credit card as a loan, it really is a common type. It lets you borrow a certain amount when you buy something with the card, and then you pay that amount back over time. Most credit cards come with a limit (a certain amount that you can borrow up to before you will be unable to borrow more).

  • Debt consolidation loan: If you have several debts, you can put them into just one new loan.7 This type of loan can make it easier to focus on making just one payment. If you don’t accumulate any more debt, when you pay off the debt consolidation loan, you’ll be debt-free.

Secured loans explained

When you take out a secured loan, you use an asset as collateral such as your home or car.8

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.9 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. 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.

This site is for educational purposes. The material provided on this site is not intended to provide legal, investment, or financial advice or to indicate the availability or suitability of any Capital One product or service to your unique circumstances. For specific advice about your unique circumstances, you may wish to consult a qualified professional.

  1. “Planning & Progress Study 2018.” (n.d.) Retrieved October 18, 2018, from https://news.northwesternmutual.com/planning-and-progress-2018

  2. “Collateral.” (n.d.) Retrieved October 18, 2018, from https://www.investopedia.com/terms/c/collateral.asp

  3. “How Repossession Works: When the Bank Takes Your Car.” (n.d.) Retrieved October 18, 2018, from https://www.thebalance.com/repossession-when-the-bank-takes-your-car-315103

  4. Investopedia Staff. (n.d.) Unsecured Loan. Retrieved October 18, 2018, from https://www.investopedia.com/terms/u/unsecuredloan.asp

  5. “What are personal loans?” (n.d.) Retrieved October 18, 2018, from https://www.debt.org/credit/loans/personal/

  6. “Secured Versus Unsecured Loans for Higher Education.” (n.d.) Retrieved October 18, 2018, from https://www.discover.com/home-equity-loans/article/secure-vs-unsecure-loans-for-higher-education/

  7. Nicastro, S. (June 8, 2018). Types of Personal Loans. Retrieved October 18, 2018, from https://www.nerdwallet.com/blog/loans/personal-loan-types/

  8. Caldwell, M. (February 20, 2018). Is a Secured Loan a Good Option? Retrieved October 18, 2018, from https://www.thebalance.com/secured-loans-2386169

  9. Long, E. (March 2, 2018). A Guide to Secured Loans. Retrieved October 18, 2018, from https://www.magnifymoney.com/blog/personal-loans/secured-loans/