How to Money, Episode 5: What is a Secured Loan?

Debt to Income Ratio

On the latest episode of our “How to Money” video series, we talk about secured loans. Not sure what a secured loan is, or whether you should apply for one? Perfect! This is just the video for you.

Enjoy!

What is a Secured Loan?

There are two types of loans: secured loans and unsecured loans. A secured loan is a loan that’s backed by collateral, while unsecured loans are loans that do not involve collateral.

What’s collateral? It’s a valuable piece of property that you offer up as part of the loan agreement. If you can’t pay back your secured loan, then the lender can seize the collateral and sell it. These loans are much less risky for lenders, which has its benefits for the borrower as well.

Since unsecured loans do not involve collateral, they are much riskier for lenders. The only thing backing them is the borrower’s promise that they will repay the loan. If the borrower can’t pay the loan back, then the lender stands to lose a lot of money.

Types of Secured Loans.

The two most common types of secured loans are mortgages and auto loans.

A mortgage is a loan that’s secured by real estate while an auto loan is secured by a car, truck, or motorcycle. In many cases, both mortgages and auto loans are structured as installment loans and are secured by the house or car that the loan is being taken out to purchase. In cases like these, the buyer doesn’t technically own the house or the car until the loan is fully paid off. Once it is paid off, they are said to own it “free and clear.”

However, not all secured loans are structured this way. Ask any homeowner and they’ll be familiar with a home equity loan (or line of credit), which are loans taken out against the value of your house. If you still owe a mortgage on the house, the home equity loan is secured by the value of your home above and beyond what you still owe. Due to their low interest rates, they can often serve as debt consolidation loans.

Most credit cards are unsecured, but there are secured cards as well. The collateral for these cards is a deposit that also sets the card’s credit limit. You deposit $500, and you get a $500 credit limit.  If you can’t pay the card back, the lender can use your deposit to pay it off instead.

Secured credit cards are easier to get approved for then unsecured cards. But what sets them apart from most bad credit loans and no credit check loans is that (in most cases) your payments get reported to the credit bureaus.

This means that secured credit cards can be a great way for people with not-so-great credit scores to start rebuilding their credit history.

To read more about secured credit cards, check out our blog post, Secured Credit Cards: 3 Ways to Use One to Rebuild Bad Credit

Here’s an example of a Secured Loan.

Let’s say you’re looking to buy a house, and the house costs $300,000 dollars.

Most people wouldn’t be able to buy that house outright. To do so, they would have to save up $300,000 in one lump sum. Is that something you’d be able to do?

(We’re guessing not. And don’t worry, we wouldn’t be able to either.)

So instead, this person takes out a mortgage that lets them pay that $300,000 off over time. Of course, it also means that they’ll be paying interest on the loan. So they’ll end up paying quite a bit more than just $300,000 by the time everything is said and done.

EVen when you’re taking out a secured loan to purchase a house or car, a down payment is usually required. This is a certain percentage of the total asking price that you pay up front. The more you pay upfront, the less you have to borrow, and the more money you’ll save overall. Lenders like it too because it means less risk.

What happens if you take out a mortgage to buy that $300,000 house and then you can’t pay it off? Well, If you can’t make your payments on the loan, then the lender will seize the house, kick you out, and then sell it in order to make up the money they lost. With an auto loan, they’ll take your car back.

For mortgages, this process is called “eviction.” With an auto loan, it’s called repossession.”

The pros of Secured Loans.

The biggest advantage of secured loans is that they come with much lower interest rates than unsecured loans, and they are generally much easier to get approved.

This is because secured loans pose much less risk to lenders. If they give out a secured loan and the borrower is unable to pay them back, they can just seize the collateral and sell it. They might not make back everything they lost on the loan, but, at the very least, they’ll have lost a lot less.

With unsecured personal loans, the stakes are a bit different. There is a much greater chance that the lender will lose a lot of money if the borrower can’t pay the loan back. Even if they sell the debt to a collection agency, they’ll do so at a fraction of the full amount that’s owed.

This is why the interest rates for unsecured loans are so much higher because lenders have to insure themselves against the higher levels of risk. It’s also why lenders are much less likely to approve them. Your credit score is a major factor when applying for an unsecured loan.

Without secured loans and collateral, the world would look very different. People would have to save up a lot of money to make big purchases like homes and cars. And the only people who’d be able to borrow money would be people with tons of wealth and a sterling credit history.

Basically, if you were a regular person, a world without secured loans would not be great.

The cons of Secured Loans.

If you default on an unsecured personal loan, you’ll get sent to collections, which sucks.

But default on a mortgage? You’ll get evicted. Default on an auto loan? Your car gets repossessed. Those suck way more.

So the interest rates may be lower for a secured loans, but the risks for you, the borrower, are much, much higher.

There are also predatory secured loans, like title loans, where the rates are super high. These are short-term loans, similar to payday loans, that are secured by the title to your car, truck or motorcycle. If a borrower is unable to pay the loan back on time, they can then (depending on state regulations) roll the loan over or reborrow it.

It’s a great way for lenders to rack up excessive fees and interest. According to a study from the Consumer Financial Protection Bureau (CFPB), the average annual percentage rate (APR) for a title loan is over 300 percent. Yikes!

To read more about title loans, check out our article: Texas: The Wild West of Auto Title Lending

Here are your takeaways

  • Secured loans are backed by collateral, while unsecured loans are not.
  • Secured loans mean less risk for lenders, which means lower rates for borrowers.
  • Secured loans allow people to make big purchases, like homes and cars.
  • Mortgage loans and auto loans are the most common types of secured loans.
  • Title loans are predatory secured loans.

Be sure to check out our other How to Money episodes, where we cover credit scores, the debt to income ratio, and more! You can request topics for future How to Money episodes by emailing us or by shooting us a tweet at @OppLoans.

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