A secured loan is a loan that requires some form of collateral to protect the lender. Collateral, in this case, can be any physical or financial asset such as a home or car that can serve as insurance for the lender in case you default on the loan.
Secured loans are often attractive to lenders because they assume less risk. Likewise, borrowers with less-than-ideal credit may secure better terms with a secured loan rather than an unsecured one.
How Do Secured Loans Work?
Secured loans require you to offer assets as collateral to secure the loan. In doing so, you’re giving the lender the right to claim your collateral to pay off the loan if you default. That claim is called a lien.
The lien remains until you pay off the loan and the lender releases the lien. When the lien is lifted, the collateral returns to the borrower. On the other hand, if you don’t pay your loan as agreed, the lender will sell your collateral to cover any losses they incur on the loan.
Because lenders have a legal claim to this property, they take less risk should you fail to pay your loan back. Because of this, lenders are more likely to provide better terms to borrowers with collateral. Likewise, they make extend secured loans to borrowers who would not qualify for an unsecured loan.
The Advantages and Disadvantages of Secured Loans
Anytime you borrow money from a lender, risk is involved. Before you take out a secured loan, consider the pros and cons of doing so.
- Lower Interest Rates. Secured loans are not as risky to the lender as unsecured loans, since they come with collateral. As such, lenders may offer lower interest rates for secured loans.
In fact, lenders may even compete for your business. You see this competition a lot with mortgage lenders, who allow borrowers to search for the best loan terms available.
- Higher Loan Amounts. With the lower interest rates comes larger loan amounts. As with any investment, it comes down to risk. The maximum amount for secured loans can be much higher than for unsecured credit cards.
- Credit Establishing Opportunities. Repaying your secured loan in full and on time can have a positive impact on your credit history. This makes secured loans a great way to build positive credit when you have a poor credit history.
- Collateral Risk. The biggest pitfall secured loans present is that you can lose your collateral. That can be quite a blow if the collateral is something important, like your house or car.
In many cases, the collateral can be repossessed immediately upon default. In some instances, lenders may claim the asset as soon as you get behind on payments. Even worse is that some states are not required to notify borrowers when they seize their collateral.
- Credit Risk. As with any loan, not making timely payments can result in damage to your credit history and your credit score. In turn, the damage could make it difficult to borrow money going forward.
Types of Secured Loans
There are several kinds of secured loans available to consumers:
- Mortgage Loans
Mortgage loans are secured against the borrower’s home. If you do not pay your loan, your property may go into foreclosure to pay off your balance.
- Home Equity Loan or Line of Credit
This loan is a second mortgage in which the collateral is the equity in your home. “Equity” is simply the difference between the value of the home and how much you still owe on the mortgage used to purchase that home. Like the original mortgage loan, you’ll lose your home should you fail to make your loan payments.
- Vehicle Loans
Loans for cars, motorcycles and boats are a type of secured loan since the vehicles themselves are the collateral that secures the loan. As is the case with a mortgage, failing to repay your secured loan can lead to a repossession.
What Assets Can Serve as Collateral?
Typically, lenders seek collateral that they can sell quickly and for around the same value as the amount of the secured loan. Here are some examples of secured loan collateral.
- Real Estate. Homes and property are some of the most common forms of collateral. Mortgage loans are secured by the property they purchase, meaning the bank can foreclose on homes and land when borrowers default on the loan.
- Vehicles. Cars and other vehicles are other popular forms of collateral for a secured loan. When you use an auto loan to purchase a car, the loan is usually secured by the value of the vehicle, often determined by Kelley Blue Book.
- Investments. You can also use stocks and other investments to get a secured loan, which is often referred to as securities-based loans or stock-based loans. Many private banks and investment brokerages offer these loans to their clients who already hold investments with them.
As with other secured loans, your asset, in this case, stocks holdings or other investments, is the collateral for the loan. Lenders commonly extend credit limits equal to the full value of your investment portfolio.
Be aware, however, that your portfolio’s value can fluctuate, which may result in a problem for your loan. Say the value of your investments falls below the amount you owe on the loan. Your lender may want extra money to counterbalance the value of the collateral against the loan amount.
- Savings. Many banks and credit unions offer savings-secured or certificate-secured loans to their customers. These loans give you the opportunity to keep your cash in a deposit account, such as a savings account or a certificate of deposit. An attractive benefit to saving secured loans is that you can earn interest on your deposit while using them as collateral to purchase something you need.
Lenders have to make sure the value of the collateral is sufficient enough to repay the loan if you default on it. That means your property may need to be appraised
Although the lender has a legal interest in the asset, under most circumstances you get to keep it. The lender could place restrictions on the loan terms to protect the asset. For example, your auto loan may require you to keep liability coverage on your vehicle.
What to Do If You Can’t Make Your Loan Payments?
If you fall behind on your secured loan payments, take these steps:
Contact Your Lender
It’s vital to keep the lines of communication with your lender open. Be straight with them about late payments and they might be more likely to extend the extra time for repayment. You may even be able to work out a new repayment schedule.
The flip side is that if you ignore the lender, and particularly if you don’t respond to their notices, they may start the process to repossess your loan collateral.
Adjust Your Budget
Your best option to get back on track with your payments is to avoid borrowing more money.
Take a moment to add up your income and expenses. Review your living expenses and look for ways to reduce your costs.
If you still don’t have enough room in your budget to make a minimum payment, determine how much you can afford to pay. Then contact your lender and see if they can work with you.
Having a sound budget can help you take control of your money and identify a path to get out of debt.
If you’re behind on your mortgage loan, call your lender and a HUD-approved housing counselor for free help on avoiding foreclosure.
Credit counselors are an option if you would like to learn more about managing your money. Some credit counseling organizations are non-profit. Ask them what their fee is and what support services you can expect to receive.
The Bottom Line
Secured loans offer many benefits, like lower interest rates and longer repayment terms. The downside, however, is the risk involved. Namely, you could lose the collateral you put up to secure the loan.
If you’re considering getting a secured loan, do your research and find an affordable loan with good terms. Make sure you make your payments on time each month and have a backup plan in case you run into financial issues that may prevent you from repaying your loan.
With the right planning to address those important issues, you can have a successful experience with a secured loan. That is, you can get the right loan for you without losing any valuable assets.