What is an unsecured loan?
Unsecured loans are generally the most straightforward types of loans. A bank (or another lender) will lend a sum of money to an individual at a certain rate of interest, to be paid back at regular intervals (usually monthly) over a set period of time, until the debt (including any interest accrued) has been repaid.
Instead of using collateral (eg a home), unsecured loans tend to be made on the basis of an assessment of the affordability and reliability of the borrower. The lender may ask for proof of a regular monthly salary and will carry out a credit check when deciding whether to make a loan to a certain individual and to calculate the maximum amount they are willing to lend etc.
Credit scores and defaults are then used to determine an individual's suitability for a loan. For information, read Credit scores and defaults.
What is a secured loan?
Secured loans are typically used where significant amounts of money are involved (eg above £10,000). In this case, the lender will require the individual to put forward a source of equity (normally their home - which is why secured loans are also known as homeowner loans) as security for the loan. If the borrower defaults on their agreed repayments or refuses to pay back the loan, the lender can take steps to gain hold of the security (ie equity in the home), in order to receive the amount of loan outstanding.
What are the pros and cons?
If a smaller amount of money is needed, unsecured loans tend to be safer than secured loans, since a home is not being put up as collateral. However, people with a poor credit score will struggle to obtain this type of loan and interest rates may be higher. Lenders can also use a charging order to convert an unsecured loan to a secured loan.
Secured loans are riskier because the borrower is putting their home on the line. However, the use of collateral makes it much easier to obtain a loan, particularly larger amounts. It will often be the only way for people without a regular source of income and/or a poor credit history to get a loan.
Are there any alternatives?
Homeowners may decide to remortgage their property as a way of raising cash; this allows them to take advantage of an increase in house prices or any equity.
Credit card borrowing is another option, but this normally comes with a fee which is a percentage of the amount borrowed. Occasionally this is interest-free for a fixed period (eg 12 months) after which high rates of interest are applied.
Borrowers with poor credit histories who only need a small loan (ie to keep a steady cash flow until their next salary payment) sometimes turn to 'payday lenders'. These loans are easier to obtain but the associated interest rates are usually extortionate.
Can an unsecured loan turn into a secured loan?
Homeowners who wish to convert an unsecured loan to a secured loan can decide to take out a secured loan and use this to pay off the unsecured loan.
Sometimes a lender will be able to convert an unsecured loan to a secured loan, by using a charging order.
What is a charging order?
Homeowners who have defaulted on repayments of an unsecured loan, and who have a county court judgment (in England and Wales), a money judgement (in Scotland) or other court judgment against them, are vulnerable to charging orders. If a lender obtains a charging order from the court, they are potentially able to force the borrower to sell their home in order to repay the debt; this effectively transforms an unsecured loan into a secured loan.
For further information, read Charging orders.