When you need to borrow money, it often feels like the people who lend it speak a different language. You'll hear all manner of terms and phrases, like "secured loan," "unsecured loan," "collateral," "revolving credit," and countless other unfamiliar words.
A secured loan is a loan that is backed by financial assets you own. Everyday items used to secure loans include homes, vehicles, RVs, boats, etc. Sometimes, the things you purchase with the loan act as collateral to secure the loan. The idea behind this is that borrowers have additional motivation to repay the loan if defaulting on the loan means losing something valuable to them.
In some instances, the item does not have sufficient value or liquidity to serve as collateral in its own right, and additional security may be required. Lenders use complex formulas to determine an item's worth, the risks associated with the article, and other factors when determining sufficient collateral for lending purposes.
How Does a Secured Loan Work?
Now that you understand the basics of a secured loan, it is time to dig in a little deeper to learn how they work. The simplest explanation is this. You want to buy something but lack the cash, so you need someone to loan you the money.
Even with excellent credit, some loans must be secured. This is often true of high-ticket items like homes. For most consumer loans, the thing that you're purchasing will serve as collateral. That isn't always the case, however. In some situations, alternative collateral sources can be used to secure a loan. The lender must assess and approve the collateral, and you must agree on the loan terms.
You are considered in default if you do not repay the loan as agreed. If you default on the loan, the lender takes possession of the items established as collateral to help the lender recoup losses associated with the loan.
Types of Secured Loan Collateral
Many types of collateral are used to secure loans, and those listed below are among the most common types. However, more options are available depending on the value of the loan and the types of lenders you're doing business with. These are a few prime examples of secured loan types used today.
- Mortgages. The home you're purchasing serves as the collateral for the home, and failure to repay the loan results in the house's foreclosure.
- Home equity loans. These loans use the equity in your home as collateral while releasing a set amount of funds to you that get repaid on a fixed repayment schedule.
- Home equity lines of credit. Often referred to as HELOCs, these loans also use the equity in your home to create a line of credit, which can be accessed at any time.
- Auto loans. With these loans, the vehicle serves as security for the loan, and if it isn't repaid, the vehicle may be taken.
Other standard options involve using land to secure loans used to purchase land; of course, the land can be used to secure loans for improvements to the property, such as building a home.
Additionally, business owners often use inventory, equipment, and/or buildings to secure loans for expansion, and special projects, purchase new equipment and even hire new employees. The key is that something of value secures the loan and will be forfeited if you fail to repay the loan according to the loan terms.
Other items that can be used to secure loans, depending on the loan and the lender, include the following:
- Cash accounts.
- Investment portfolios.
- Insurance policies.
- Jewelry and precious metals.
- Art and collectibles.
- Equipment and machinery.
As long as the value of the items used to secure the loan is on par with the loan itself, there is likely to be a lender willing to work out a deal if the lender views you as an acceptable risk.
Benefits
A few distinct benefits are associated with secured loans, some of which may surprise consumers. They include the following:
- Easier loan conditions and more favorable loan terms for borrowers.
- Lower interest rates compared to unsecured loans.
- More significant loan amounts are approved for real estate and business equipment.
It's not all sunshine and roses, though. There are a few potential downsides related to secured loans to keep in mind.
Drawbacks
The big drawback in the room is that you can lose the items used to secure the loan if you cannot repay the money you borrowed. That is never the intention, but sometimes life happens, and the penalty for default is high. Another drawback is that approval for secured loans often takes longer than approval for unsecured loans. This results from the complex calculations used to evaluate and assign value to items used as collateral.
Using Secured Loans Responsibly
The most responsible thing borrowers can do regarding secured loans is to repay the loan as quickly as possible. Your collateral is at risk as long as you owe money, and this is true if you're one month into a 30-year mortgage or 20 years into the mortgage.
If you are having trouble repaying a secured loan, consider acting before things get out of control. You might be able to lower your payments by refinancing for a longer term or lower interest rate to provide little breathing room and allow you to afford your debt more comfortably.
Alternatives to Secured Loans
If you do not need to borrow large sums of money or have exceptional credit, consider unsecured loans instead of secured ones. These loans often have higher interest rates but may be acceptable for your needs. The key is to find the loan that best meets your needs, your means, and what you consider an adequate level of risk.