Financial Advice

Understand Your Credit

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Secured vs. Unsecured Credit—Know the Differences

You can choose from a wide array of credit, each with pros and cons. Do you have the best kind of credit to meet your goals? Understanding the differences can help you make the most of the credit you build. Here is the low-down on some terms you may hear.

Secured Credit
With secured credit, a lender gives you a loan with collateral as a guarantee that the loan will be repaid. Collateral is an asset you own, usually a home or car. If you miss a certain number of payments, the lender can take the collateral. The collateral gives the lender reassurance that the loan is a low risk for them. The lender doesn’t have to take you to court and win a judgment before foreclosing on your home or repossessing your car. You might encounter two types of secured credit, closed-end and open-end:

  • Closed-end: The item you purchase with the loan—such as a home, vehicle, or boat—acts as collateral. You make equal monthly installments over a specified time. This is usually the best, and sometimes the only, way to buy very expensive items. Buying a car with a credit card would result in very high interest costs.

  • Open-end: A cash deposit or an asset guarantees the credit, whose balance rises and fall as you use it. These debts can be repaid in a single payment or in multiple, equal or unequal payments. Examples of secured, open-end credit include secured credit cards and home equity lines-of-credit.

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    Why get a secured, open-end line-of-credit? Secured credit cards allow you to put down a small deposit as security and you can start charging—and building a positive credit history. Interest rates for home equity lines-of-credit are typically low. Some of the interest you pay on a home-equity loan might be deductible from your income taxes if certain requirements are met. For example, depending on when you took out the loan, you could deduct only interest on the portion of proceeds used to improve the home itself.

    Bear in mind that with a secured credit option, your property is at stake. If you can’t make the payments, your collateral is in jeopardy.

Unsecured Credit
Lenders grant unsecured credit without requiring anything from you as collateral. This type of credit is riskier for lenders, because if you fail to pay, they must spend time and money on legal action to recoup the money they lent. This is why unsecured credit generally carries a higher interest rate than secured credit. However, if you have proven yourself as a good credit risk, you can usually find an attractive interest rate.

As with secured credit products, unsecured credit also comes in closed-end and open-end flavors:

  • Closed-end—Loans that require no collateral are types of unsecured, closed-end credit. They are sometimes referred to as signature loans or personal loans. These are repaid in equal, monthly installments.

  • Why get an unsecured, closed-end loan? They can be great for consolidating debt or for purchasing an item that you want to repay over a specific number of months or years. With a loan, you reduce your balance gradually and steadily with each payment you make. It helps you to manage your debt more easily than with a credit card, which can have an ongoing balance.

  • Open-end—An example of unsecured, open-end credit is a credit card. The card issuer sends monthly bills and informs you of the minimum payment due. If you spend more than your limit or pay after the due date, you could be assessed a penalty or fees.

  • There are several types of credit cards. The most common are general-purpose cards that can be used almost anywhere. Retail cards, on the other hand, can be used only at the sponsoring establishment—such as a department store or gas station—and its partners.

    Why get an unsecured, open-end line-of-credit? Credit cards are valuable payment tools. Some credit cards offer points, rebates, or cash-back rewards where the more you use them, the more benefits you receive. For most purchases, you will have a grace period (the number of days you are given to pay before interest charges are added to the balance). When you use credit cards responsibly, you have the opportunity to develop and maintain an excellent credit history, which could help you finance other loans you may need—like a home or vehicle—at better interest rates.

Make sure to read and understand the terms of the loan, line-of-credit, or credit card before you sign. Borrow only what you need and can repay. It’s all too easy to take on more debt than you can afford. Whether the balance is secured or unsecured, the consequences for falling behind are serious. However, if you borrow wisely, you can come out ahead and achieve your financial goals quickly and affordably.