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Traditionally, you might think of a car loan as one that uses the vehicle as collateral — in other words, a secured loan. Another option exists, however: an unsecured loan where the vehicle isn’t put up as collateral, which is a significantly different type of loan structure. So, what exactly are the differences between an auto loan that’s secured or unsecured, and which is better? This post walks you through both processes and the pros and cons of a secured vs. unsecured auto loan so you can make the right decision for your situation.
What Is a Secured Auto Loan?An auto loan that uses the vehicle as collateral for the loan is considered a secured auto loan. The borrower pays back the loan by making a predetermined principal and interest payment over a certain period of time. If the loan is not paid back according to the agreement, the lender may be able to repossess the vehicle.
What Is an Unsecured Auto Loan?An unsecured auto loan, meanwhile, does not use the vehicle (or anything else, for that matter) as collateral. Instead, the financial institution looks at the credit history and financial record of the borrower when making lending decisions. If the borrower defaults on an unsecured auto loan, the vehicle is not directly at risk of being seized.
Are Auto Loans Secured or Unsecured?As the descriptions of secured and unsecured loans demonstrate, auto loans can require collateral (secured), or they can be based on the borrower’s credit and financial status without an asset being collateralized (unsecured). What’s important is to weigh the pros and cons of each before making an informed decision. Most commonly, auto loans require collateral.
Secured vs. Unsecured Car LoansWhen deciding between secured vs. unsecured auto loans, it’s important to consider the pros and cons of each.
You can explore lender’s requirements for auto loans that use the vehicle as collateral. They will likely include your:
|Secured Auto Loans||Because there’s collateral involved, it may be easier to get loan approval due to reduced risk for the lender.||If you default on payments, you may lose the vehicle.|
|Because of the lender’s reduced risk, your interest rate will likely be lower than with an unsecured loan.||You’ll need to have your credit checked, and your score must meet lender guidelines. Late payments can negatively affect your score.|
|Lower interest rates can mean lower principal and interest payments.||The value of the vehicle must be verified as high enough to support the loan amount.|
|Unsecured Auto Loans||No vehicle assessment is needed and, if you default on payments, the car is not directly at risk.||If your credit score doesn’t meet the lender’s standards, the loan may get denied or you may receive a higher interest rate.|
|You can get lower interest rates with a good credit score (in contrast to when someone has a lower score).||Overall, unsecured loans come with higher interest rates than secured loans.|
Read on for more about each along with additional information about what is needed for a car loan.
- Credit history
- Credit check results
- Debt-to-income ratio
IncomeLenders will check to make sure you have enough income to afford a car loan, and what “enough” means can vary by financial institution. Ways that lenders may verify your income can include asking for pay stubs, bank statements and/or tax returns.
Credit HistoryBecause past payment history can predict a person’s future actions, lenders want to see that borrowers have a pattern of meeting their financial obligations. As such, a review of your credit history is typically part of the loan approval process for a vehicle.
Credit Check ResultsResults of your credit check can play a key role in determining what interest rate you’re offered. Gathering information ahead of time about what rate you qualify for can help you to decide what kind of car you can afford and budget for its purchase.
Debt-to-Income RatioYour debt-to-income ratio (DTI) calculates the percentage of your pre-tax income that goes toward your monthly debt payments. Lenders like to see a lower DTI because this reduces their levels of risk, while a higher one can indicate that a borrower is carrying too much debt for their gross income.
How Can I Get an Unsecured Auto Loan?With an unsecured loan, seek out lenders that will loan on a car without requiring collateral. They will likely look at factors such as your:
Here’s more about what lenders may be looking for with each.
- Credit history
- Credit check results
- Debt-to-income ratio
CreditGood credit scores are especially important for unsecured loans because the lender makes approval decisions based on that person’s financial record and situation. The interest rate may also depend upon the individual’s credit score.
IncomeJust like with unsecured loans, a lender will want to make sure that you have enough income to make the payments. They’ll likely ask to see the same sorts of proof, such as pay stubs, bank statements and/or tax returns.
AssetsBecause the vehicle is not put up as collateral for an unsecured loan, the asset (the car) does not need to be assessed as part of the loan process and can’t be directly taken if payments aren't made. That said, defaulting can still hurt your credit score and remain on credit reports for seven years.
Car Financing OptionsWhen shopping for an auto loan, it’s important to assess your options. You’ll want to set your budget before you head out shopping, and it’s also a good idea to check your credit in advance so you have a good sense of where you stand and what your odds of qualification are. This could give you a sense of whether you may need a cosigner.Shop for car loans from multiple sources, and consider getting prequalified or preapproved. Once you have the auto loan offer in hand, it is critical to read the fine print before you commit. Specifically, keep an eye out for your interest rate, the length of a car loan, any fees and penalties and other key aspects of the agreement before moving forward. If you already have a car loan and are looking to reduce your payments or otherwise get a better deal, consider refinancing. If you’ve got a more challenging situation, such as upside down auto loans where the loan amount is higher than the value of the car, it can take more research to find the right lender.
The TakeawayAuto loans can be divided into two broad types: secured, where the vehicle is put up as collateral, and unsecured, where a borrower’s credit history and financial situation is primarily considered when a lender makes an approval decision. Although the borrowing processes are similar in many ways, there are key differences between secured vs. unsecured auto loans. It’s important to be clear about which type of loan you’re applying for and what will be right for you. If you are refinancing an auto loan, one option is to fill out a convenient application at Lantern by SoFi to receive multiple offers from partners in our network.__________________________________________________________________________
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About the Author
Kelly Boyer SagertKelly Boyer Sagert is an Emmy Award-nominated writer with decades of professional writing experience. As she was getting her writing career off the ground, she spent several years working at a savings and loan institution, working in the following departments: savings, loans, IRAs, and auditing. She has published thousands of pieces online and in print.