Secured vs Unsecured Loans

« Mortgage Refinance – Is It Right For You?

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Mar 17th, 2008 by Kenny

Both lender and borrower are faced at the outset with a basic decision – to obtain a loan that is either secured or unsecured. But, what does that mean, and what are the pros and cons of each for either party?

A secured loan is one in which the money borrowed is guaranteed to be repaid or some asset will be forfeited. The most common example is a home loan. The borrower agrees to repay on the terms of the contract, and if he or she defaults, the lender can legally claim the home as compensation.

In theory, that means that if you miss a payment on the home loan, the lender has the legal right to foreclose and sell the property. In practice, that never happens. Among other reasons, lenders know that reclaiming a house is a long, unpleasant chore and they would be left with the necessity to sell the home to recoup the money.

No lender is going to do that for such a small misstep as missing a single payment. Even if the borrower lags by several months, at most the lender will typically send a series of firm letters demanding payment before taking any other action. Even in an active seller’s market lenders have many more important things to do and don’t want to undertake the effort of removing a homeowner and selling a house.

Nevertheless, it’s wise to realize that the lender has this right. How important or not that right is can be judged by recognizing that even with an unsecured loan, creditors have the legal right to seize assets like salary, stocks and property. This requires only undertaking a relatively simple and inexpensive legal procedure to declare the borrower in default.

But, legal procedures are only RELATIVELY simple and inexpensive – and lenders will almost always try to work out a repayment option before taking that step.

There are other differences between secured and unsecured loans that borrowers should be aware of. Since the money in an unsecured loan is not, in theory, backed by the right to seize the asset in case of default, the interest rates on them are usually higher.

The lender in that case is taking a larger risk, and they are compensated by charging higher interest. That covers losses from defaults (which are higher on unsecured loans) and is one way to change borrowers incentives. Most people will try much harder to meet a debt that is tied to their home than for an unsecured loan.

So, there are pros and cons for both borrower and lender to obtaining one type of loan versus the other. As a borrower, you may find it necessary to incur a higher rate of interest if you don’t have a home, bonds or other assets to offer as collateral. Or, you may simply want not to put those at risk.

Only you can decide in your particular circumstances whether the advantages outweigh the risks and costs.