What is a Secured Loan?
A secured loan refers to a loan contract in which the borrower puts up collateral (like their home or car) to acquire immediate cash. They agree that the lender may gain legal ownership of that collateral if the borrower fails to repay the loan.
A home mortgage is a very common type of secured loan, one using real estate as collateral. The lender is more confident you will repay the loan in a timely fashion, because you could lose the collateral – your home! – if you fail to make payments.
If you don’t have collateral, you can’t get a secured loan and thus miss out on the primary benefits, which are a lower interest rate, higher loan amount available and extended repayment period.
Credit card debt, on the other hand, is an example of an unsecured loan, since the lender can’t seize an asset to recoup all or part of what you owe if you default. The fact there is no asset to recoup is main reason that unsecured loans come with higher – most times considerably higher – interest rates.
Before offering any sort of loan, lenders are likely to check a borrower’s income and credit history to learn who they’re dealing with. Most are more comfortable lending money if an asset secures the loan. For a consumer, that should mean lower interest rates and higher borrowing limits, depending on the value of the collateral.
How Do Secured Loans Work?
The lender often will want collateral that has a greater value than the loan amount. For instance, you might be able to borrow $1,000 if you offer your $2,000 car as collateral. If you default, the lender gets your car and sells it, recouping the money and making a profit on the deal.
Obviously, no one wants to lose collateral. Lenders know this, so they generally are willing to accept a lower interest rate payment on the loan knowing that the borrower has a big incentive to repay it. For that reason, secured loans are often easier on your wallet.
Interest rates are partly tied to your ability to pay down the loan and the value of the collateral you put up. Consider the process used to make home loans. Lenders will ask for documentation about your income and will research your credit history. They’ll also want an appraisal of the home’s value and a down payment that guarantees the lender won’t lose money if the borrower defaults. The down payment could be as much as 20% of the home’s value or insurance that guarantees that much in a default.
Assets That Can Secure a Personal Loan
Not all secured loans are structured the same way.
In the case of a home loan, the down payment gives the lender a guaranteed hedge to cover costs if the borrower defaults. The lender knows exactly what the loan is financing.
But what if the consumer wants money for something else, like to replace the house’s roof? He could use home equity, which is a major source of collateral, then get a secured loan.
Say you own a $200,000 home and have paid down $100,000 of its value. You need $12,000 for a new roof, so you ask your mortgage lender for a loan. The lender agrees to lend you the money with an interest rate far below what you would pay if you borrowed on a credit card if you agree to offer you house as collateral.
Rates for home equity loan in the summer of 2017 ranged from 5.67% for those with excellent credit scores (740-850) to 10% for those with scores as low as 620. Compare that against the national average for credit cards, which was 16.67 for the same time period.
Why the lower rate?
If you put $12,000 on plastic, the card company would run a fairly large risk. It might not get its money back if you defaulted. But if you offered the title to your home as collateral, the risk is considerably lower: You will be very reluctant to default and lose the equity, not to mention the chance the lender would foreclose to get its money back.
As the roof-replacement example illustrates, home loans are used for more than paying off a house. You can also use equity in your house as collateral to borrow for other purposes. These loans are called second mortgages, since they allow you to borrow against the equity built while repaying a primary mortgage.
There are two main types of second mortgages: home equity lines of credit and lump-sum home equity loans.
Home equity lines allow you to borrow what you want up to an agreed upon maximum over a fixed amount of time, usually 10 years. The home equity lines come with an additional repayment period of 20 years, during which you can no longer borrow and must repay the principal.
Homes certainly aren’t the only forms of collateral. Cars can be used in the same way. Auto equity loans come in two varieties: auto-refinance and auto-title loans.
Auto refinances often are made to car owners who have substantial equity in their vehicles. Lenders offer to repay the balance on the owner’s original car loan and replace it with a new loan for more money. The borrower gets the difference in cash. Refinancing a car usually involves a check of your credit.
Auto title loans are similar to payday loans. They typically come with extremely high interest rates – sometimes as much as 300% — and are very risky. Lenders normally require that you don’t have any other loans on your car, assuring that there aren’t any liens on the title.
If you fail to make payments, the lender gets title to your car and can easily repossess it. The Consumer Financial Protection Bureau said that 20% of the auto title loan borrowers have their car or truck seized by the lender for failure to repay the debt.
A cautionary word: Auto title loans can be hazardous to your economic health, as it’s easy to lose your car and the cost of the loan can be monstrously high.
Both auto-refinance and auto-title use a car as collateral, so the lender wants to make sure nothing happens to its value. For this reason, the lender will require some form of collision coverage. If you don’t carry collision insurance, you might need to arrange a credit-insurance policy with the lender in order to qualify.
Other Money: Savings, Certificates of Deposit
It is also possible to borrow against your savings, which can serve as collateral. If you have money in a savings account or a certificate of deposit, you might post it as collateral. This usually doesn’t make sense unless you need to preserve the savings for some reason. Otherwise, you end up paying interest on money you already have. While you are repaying the loan, withdrawals are prohibited from the collateral account.
You can use anything of value to secure a loan. Pawn shops make their money this way, making small loans in exchange for assets the borrower brings in. For example, a borrower may bring a microwave oven worth $50 to a pawn shop and ask for $15 loan against that secured asset. The pawn shop would require the borrower to repay $20 within five days in order to get the oven back. If the borrower defaults, the pawn shop sells the oven for something close to its value.
Pros and Cons of Secured Borrowing
Borrowing money always comes with risks. Accumulating big debts that you can’t repay puts you on the road to debt management services and eventually bankruptcy court. At the least, be sure you pay the interest on the money you borrow. Secured loans have advantages and disadvantages relative to their unsecured counterparts.
- Lower interest rates. Since secured loans come with collateral, they pose fewer risk of loss to the lender. For that reason, lenders charge lower interest rates for secured loans – often much lower rates. If you have a good credit history, a solid income and valuable collateral, lenders might even compete to lend you money. Mortgage lenders do this all the time, allowing borrowers to search for the best terms.
- Larger loans. Secured loan amounts can be much larger with lower interest rates. It all comes down to risk. If the lender has collateral available in a default, the risk of lending is diminished. The maximum amount available on credit cards is puny, by comparison.
- Better terms. Secured loans often come with longer repayment periods than their unsecured counterparts. Home loans, for example, often allow borrowers to repay a loan over 30 years. For the lender, this makes sense since real estate usually appreciates in value, adding to the collateral as the loan is repaid.
- Build your credit. Repaying a secured loan in full and on schedule will enhance your credit rating, making better terms such as lower interest rates available the next time you need to borrow.
- Loss of Asset. Far and away the biggest downside to a secured loan is you could lose your possession. This might not be a big deal if the collateral is a $50 microwave oven, but it’s a far larger concern if it’s your house, car or boat. The lender can seize your property whenever you stop making payments, even if you’ve owned the property for a long time and have made many payments in the past.
- Credit Damage. As with any loan, failure to make timely payments can lead to default, and default can damage your credit rating and your ability to borrow money in the future. Sometimes lenders will work with you during a difficult period, since repayment can take years or decades. But if you owe money, you’re at risk.
Where to Apply
Banks, credit unions and online lenders are major sources of secured loans. Each lender has its own terms, but most follow the same procedures for approving loans. Often the larger the loan, and the longer it lasts, the more involved the vetting process will be.
Mortgage loans are the most involved, requiring an analysis of an applicant’s income and credit history, a review of his or her past borrowing, an appraisal of the home’s value and a down payment requirement. Other loans are less complicated and take less time to approve.
Interest charged on loans often depends on the type of lender offering the money and the borrower’s credit history and employment status. Home loans in 2017 are available with less than 5% annual interest and come with a variety of terms including adjustable and fixed rates with varying repayment periods.
Federal credit unions offer general-purpose secured loans with maximum interest rates of 18% annually while online lenders can charge as much as 36%. Maximum loan amounts and interest rates vary from lender to lender, as do collateral requirements. When you decide how much you want to borrow and what collateral you’ll offer, go online or call banks for more information.
How Secured Loans Can Be Used
The most common use for secured loans is to renovate, repair or build on an addition to your home.
Things like upgrading your kitchen, bathrooms or family room or adding landscaping or a swimming pool, are good reasons for getting a secured loan. All of those things should increase the value of your home and thus the lender would look favorably on loaning money to cover the project.
In most cases, lenders want to know how you plan to use the money you borrow. Second mortgages, for instance, used to be called home improvement loans. Lenders would stipulate the borrowed money be used for improvements like kitchen renovations and additions. This added to the security of the loan, since the borrowed money increased the value of the asset.
Lenders still ask questions. They want to know, for example if you’re borrowing money to repay debts. That becomes a dicey proposition for lender and borrower. In general, it’s unwise to transfer unsecured debt to a secured loan, especially if the collateral is your house.
If you’re already struggling to make payments, putting your home at risk is particularly dicey. If you have debt problems, it’s better to contact a nonprofit credit counseling agency and seek advice for pursuing other options, such as debt management.
About The Author
Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].
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