There are a variety of loan options available for those looking to borrow money. But there are two main types of loans, which are secured and unsecured loans. Secured loans are loans backed with something of value that the borrower owns, referred to as collateral. Common examples of collateral include a vehicle or other valuable property like jewelry.
If a borrower is approved for a secured loan, the lender will hold the title or deed to the collateral or place a lien on the collateral until the loan is paid off in full. If the loan is not repaid, and payments are late or skipped altogether, the lender may take possession of the collateral and apply the proceeds of the sale of the collateral to the outstanding debt. The borrowing limits for secured loans are typically higher than those for unsecured loans because of the presence of collateral. Some examples of common types of secured loans include mortgages and vehicle loans.
An unsecured loan is money that you borrow without using collateral. Due to the lack of collateral, the lender faces a higher level of risk. Because of this, the interest rate may be higher and the borrowing limit may be lower. Common examples of unsecured loans include credit cards and personal lines of credit, as well as payday loans.
Bad credit borrowers have limited options, often relying on subprime loans such as payday loans. Payday loans do not require collateral to secure the loan. Payday lenders take a higher risk when they lend to people without performing credit checks because bad credit borrowers are less likely to repay debt. The risks increase when there’s no collateral to back up the loan because the borrower is not as compelled to repay the loan and the lender cannot take anything from the borrower to recoup losses. Payday lenders recognize these risks and charge enough to cover potential losses.
Payday lenders charge a flat fee for the loan, but once the long term cost of the loan is taken into consideration, the loan can be quite expensive. For example, charging $15 to borrow $100 for 2 weeks seems reasonable. However, because the length of the loan is so short (typically 2 weeks, when the borrower receives their next paycheck), the equivalent APR is actually 390%. Borrowing $100 for a year with a 15% APR would also cost $15, but the borrower would have a much longer time to repay the loan. Unfortunately, getting approved for a credit card or loan with a 15 percent interest rate is difficult with bad credit, and desperate borrowers can be driven to take out risky payday loans to make ends meet.
Still, there are better options for borrowing. Even borrowers who aren’t eligible for a low-interest loan from a bank or credit union should consider payday loans a last resort. Installment loans are also unsecured, but offer lower interest rates and longer repayment terms, which make them easier to manage for most people. These loans also help build credit, giving borrowers more options for the future.