Secured vs Unsecured Loans

by William Blake

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.

This is serious because it means if you default on even one payment the lender can take your home in foreclosure and sell it for payment of the debt. In reality, the lender would not take such aggressive action after only one missed payment. The foreclosure and sale of a home is a long and costly process that lenders try to avoid if at all possible.

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.

While this may be the case it would not be smart to ignore the fact that the lenders have this right. The reality of the lender’s rights in connection with a secured loan can even be seen with unsecured loans. Even when a borrower has not pledged property as security for a loan, if a borrower defaults on a loan the lender, through simple legal proceedings, can confiscate property, or seize other assets.

However, taking legal action is still an expense for the lender and requires some time and effort that they would rather not sacrifice. In most cases, they prefer to work out a payment arrangement.

Typically the interest rate on an unsecured loan is higher than secured loans. This is because the lender is taking a greater risk since the money is not secured by assets or property.

Since the lender will incur more loss on unsecured loans defaulted on, they make up for this potential loss by charging a higher rate of interest. Sometimes that higher interest rate will encourage borrowers to select a secured loan. Lenders prefer that because the borrower has more incentive to repay the loan when it is attached to their property.

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