How do secured loans build credit differently than unsecured loans?

Introduction

Building credit is an important part of financial responsibility and independence. However, many people are unsure of how different types of loans impact their credit in various ways. Secured and unsecured loans are two major categories of loans that people commonly use to establish or improve their credit, yet they function quite differently under the hood.

Defining Secured vs Unsecured Loans

To start, it’s important to define what distinguishes a secured loan from an unsecured loan at their core. The main difference lies in what is used as collateral for the loan:

Secured loans are loans where the borrower pledges an asset as collateral. If the borrower defaults on payments, the lender has the right to seize the collateral to recover their losses. Common examples of secured loans include auto loans, mortgages, home equity lines of credit (HELOCs), and certain personal loans.

Unsecured loans do not require collateral. The borrower’s promise to repay is the only security backing the loan. Unsecured personal loans, credit cards, medical bills and student loans are typical examples that do not have collateral attached.

So in summary – secured loans have an asset (like a car or home) tied to the loan that can be repossessed if payments are missed. Unsecured loans rely solely on the borrower’s credit history and income/expenses to determine risk and do not have collateral.

Loan Underwriting Process

The underwriting process a lender uses to evaluate applicants also differs based on loan type. Let’s examine how:

Secured Loans

For secured loans, the lender will closely analyze two key areas – the borrower’s credit history/profile AND the value of the collateral pledged.

Some factors considered in the borrower’s credit check include:

• Credit scores from all three major bureaus
• Payment history on all existing accounts
• Amount of existing debt obligations
• Length of credit history
• Public records like bankruptcies, judgements, or liens

They will also get an appraisal or independent valuation of the collateral to ensure it is worth more than the loan amount. This protects the lender if the loan has to be repossessed.

As long as the borrower has fair-to-good credit and the collateral is deemed sufficiently valuable, secured loans tend to have more flexible underwriting compared to unsecured loans thanks to the added protection of possessing a repossessable asset.

Unsecured Loans

Since unsecured loans have no collateral, lenders take a much closer look at a potential borrower’s full financial picture and repayment ability when underwriting. Key factors analyzed include:

• Credit profile (as described for secured loans)
• Employment history and income stability
• Debts, expenses, and discretionary income available each month
• Bankruptcy history (if any) must be older
• Purpose of the loan (to better assess ability and willingness to repay)

Unsecured loans require borrowers have well-established, consistent credit profiles to offset the lack of collateral. Stricter qualifying guidelines means some borrowers who could get a secured loan may be denied an unsecured option.

Credit Reporting

Once the loans are open, the way payments are reported to the major credit bureaus – Equifax, Experian, and TransUnion – also varies between secured and unsecured loans:

Secured Loans

For secured loans, lenders will report the account, loan amounts, payment history, credit limits, balances, and loan terms monthly to the bureaus. On-time payments demonstrate responsible borrowing and help build a positive track record over time.

Late or missed payments, however, severely damage credit and start the clock on negative marks staying on credit reports for up to 7 years. The lender has the option to repossess the collateral if needed after missed payments as well.

Unsecured Loans

Reporting for unsecured loans mirrors that of secured loans – monthly updates on accounts, balances, limits and payment activity. One key difference is that lenders are not able to repossess anything if the borrower defaults, so unsecured loans carry inherently more risk for the lender.

To compensate, lenders will usually report delinquencies to credit bureaus faster than for secured loans, like 30-60 days past due versus 90-120 days. This causes a bigger and quicker hit to the borrower’s credit following a late or missed payment on an unsecured product versus secured.

In summary, while reporting is similar, secured loans give borrowers a bit more flexibility if hardship strikes compared to unsecured options due to the value backing the loan.

Long-Term Credit Building

The biggest divergence in how secured versus unsecured loans impact credit comes from the long-term effects of responsible payment histories over years:

Secured Loans

Consistently making monthly payments, especially for long-term obligations like mortgages or auto loans, establishes a lengthy record of trusted repayment. This significantly boosts credit scores over 5-10+ years through factors like:

• Length of credit history increase
• Mix of accounts (installment loans like these are valuable)
• Low debt-to-income ratios seen
• No negative payment marks

Positive secured loans remain on credit reports for 10 years after being paid off, continuing positive influence. Overall, secured products are excellent for gradually building “good credit” status through time.

Unsecured Loans

While responsible repayment of unsecured debt still builds a positive payment history over time the same way, there are a couple limitations versus secured options for boosting credit scores long-term:

• Unsecured accounts (like credit cards) cap out at a maximum $10,000-20,000 limit vs larger secured loans
• Since they carry more risk, unsecured products tend to stay on credit reports for only 5 years after closing (shorter tail)

So maximum long-term benefit from unsecured loans plateaus sooner versus secured loans, which allows greater debt amounts reported for longer before aging off credit reports. Secured loans provide the potential for highest credit score builds over many years of on-time payments when used responsibly.

Choosing the Right Option

Now that the distinct ways secured and unsecured loans impact credit are thoroughly explored, how should consumers decide which type is best for them? There are a few factors to consider:

• Credit profile – Secured may be the only approval option if credit is limited. Unsecured only for those with longest histories.
• Repayment ability – Secured has more flexibility if hardship arises. Unsecured leaves no collateral safety net.
• Funding need – Financing larger purchases/debts via secured loans (house, car). Unsecured best for smaller amounts.
• Goals – Longest credit building? Choose secured. Responsible use of flexible credit? Unsecured may fit better.
• Risk tolerance – Understand secured default damages credit/equity. Unsecured defaults still damage but lender can’t repossess.

In summary, while both types of loans build credit demonstrably when used responsibly, secured loans tend to provide greatest long-term benefits for scores due to greater amounts reported for longer over time. But unsecured does help establish credit for those first starting out.

FAQs about Secured vs Unsecured Credit Building

Now that we’ve covered secured and unsecured loans in depth, let’s address some of the most frequently asked questions consumers have:

What happens if I miss a payment on a secured loan?

Missing payments on a secured loan severely damages your credit scores and starts repossession proceedings by the lender. They can seize the collateral, which may be sold to help recover costs. You’ll face credit score hits, collection attempts, and possibly a lawsuit if a deficiency is still owed after collateral sale. It’s important to avoid missing secured loan payments whenever possible due to these serious consequences.

How quickly can unsecured loans build credit?

Responsibly using an unsecured credit card or personal loan and making payments on time each month can begin building your credit profile within 3-6 months of opening the account. However, the maximum benefit levels off sooner than secured loans reported for 5+ years. It may take 1-2 years of on-time payments with credit limits/balances increasing gradually over time to see significant score boosts from unsecured options alone.

Is it better to use secured vs unsecured loans first?

In general, it’s recommended that those new to credit or rebuilding it after issues start with a secured loan or credit-builder loan if possible for approval assurance. Use it responsibly for 6-12 months, then apply for an entry-level unsecured card. Once both are managing successfully for a year, you’ll have options open for better unsecured offers and larger auto/mortgage secured loans over the following years that further boost credit profiles long-term.