You just applied for a private student loan from your bank and received your rate. You notice the interest rate is much higher than the rate for your car loan from the SAME bank. What gives?!?! While these are different loans, there is one particularly important distinction between the two. The car loan is a “secured” loan and the student loan is “unsecured.” Understanding the differences between the two is a major step in achieving financial literacy and it is part of the journey to improving your long-term financial health.
What is a secured loan?
To put it simply, a secured loan is one that has collateral attached to the loan, like your car. While you do not own your car yet, your bank holds onto the title until the loan is paid off. The bank has an asset that it can sell should you stop paying on the loan. Since they still have an asset and can recoup any potential outstanding balances, it reduces the risk associated with the loan. Since the loan is considered less risky, you are offered a more favorable interest rate and you may be able to borrow more money and for a longer repayment period (term).
Unfortunately, personal loans, credit cards and student loans do not have any collateral except… well…. you, and despite how great you are, lenders look at a bunch of variables to assess the risk of lending you money.
The Five C’s of Credit
While your bank likely believes that you can repay the loan, you will be judged based on the five C’s of credit:
- Capital – money in savings or investment accounts
- Character – can include credit score, employment history, and references
- Capacity – income and current debt
- Collateral – personal assets offered as collateral, like a home or car
- Conditions – the terms of the loan
As a young adult just starting out on your financial journey, it’s unlikely that you have a lot of capital, a high credit score, high income or own a home or a car you can use as collateral. Sorry to say, this impacts the conditions of the loan – especially the rate! Learn more about the Five C’s of Credit here.
How do I get a better rate?!
With an unsecured loan, there is one way to mitigate unfavorable conditions and improve your chances of getting a loan and/or a better rate. Find a cosigner. If you can’t pay the loan, the cosigner is on the hook, but a cosigner with great credit history and a credit score makes your bank feel more secure that the loan will be repaid somehow… reducing the risk of the loan. This means you’ll get more favorable terms, including a better rate, which in turn, should reduce how much you pay over the life of the loan.