Defining Secured & Unsecured Loans
When creditors lend money, they look for reasonable assurance that the money will be paid back. A borrower's excellent credit history can help soothe the fears of the lender, especially if the loan amount is relatively small. For larger loans, however, a collateral of some kind is usually required, which the borrower can confiscate in case of default. Loans backed up by such collateral are referred to as secured loans.
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Basic Unsecured Loan
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The balance on a credit card is a typical unsecured loan. While the credit card issuer checks your employment status, annual income, present outstanding debt and credit score, the issuer has no specific collateral. In other words, if you fail to pay your balance, there is no specific asset that the issuer can confiscate and sell to recover its losses. The loan is backed up, primarily, by your reputation (in the modern world this is your credit score and history).
Secured Loan
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The mortgage on your home, on the other hand, is a typical example of a secured loan. The loan is secured by the home, which the bank can confiscate and sell if you are unable to pay your mortgage. To assure that this collateral does not vanish before the loan is paid back, the lender will place restrictions on the sale of the house. This is almost always the case with secured loans. The collateral backing up the loan cannot be sold without the consent of the lender.
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Collateral Depreciation
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It may appear that lending money for a mortgage, backed up by a home, is a risk-free proposition for the bank. However, the bank does take an appreciable risk, due to two factors. First, the value of the home may drop significantly as many homeowners have found out during the recent financial crisis. The value of almost anything backing up a loan can decline. Therefore, the lender may not recover the full value of the loan by confiscating and selling the collateral in case of default.
Recovery Cost
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Furthermore, the process of confiscating and selling collateral is often a costly process. The lender must often take the borrower to court, and therefore pay lawyer as well as other legal fees, and then incur expenses while selling the collateral. When selling a foreclosed home, the bank must pay for a broker and clean up the house, for example.
Interest Rates
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Despite the fact that even secure loans are not fully secure, they do provide a greater degree of protection to the lender than unsecured loans. As a result, the interest rate on secured loans is usually lower, and you can borrow a larger amount when you can post collateral.
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References
- Photo Credit old one dollar image by cegli from Fotolia.com
