Unsecured VS. Secured Loans

Together the lender and borrower are faced at the outset with a critical decision - to get a loan that is either secured or unsecured.  But, what does that mean, and what are the pros and cons of each for both party?

A secured loan is one in which the money borrowed is assured to be repaid or a number of asset will be forfeited.  The most general example is a home loan.  The borrower agrees to pay back on the terms of the contract, and if he or she defaults, the lender can legally take the home as payment.

In principle, that means that if you miss a payment on the home loan, the lender has the lawful right to foreclose and sell the assets.  In practice that never takes place.  Among other rationalities, lenders know that reclaiming a house is a time-consuming, unpleasant task and they would be left with the inevitability to sell the home to get back the money.

No lender is going to do that for such a small slip-up as missing a single payment.  Even if the borrower lags by quite a few months, at most the lender will normally send a series of firm letters requiring payment before taking any other step.  Even in an active seller’s market, lenders have lots of important things to do and don’t like to carry out efforts of getting rid of a homeowner and selling a house.

Even so, it’s clever to understand that the lender has this right.  How important or not that right is can be evaluated by knowing that even with an unsecured loan, creditors have the lawful right to grab hold of assets like salary, stocks and property.  This calls for only undertaking a fairly simple and inexpensive legal course of action to proclaim the borrower in default.

But, legal procedures are only reasonably uncomplicated and inexpensive - and lenders will almost at all times try to figure out a repayment alternative before choosing that step.

There are further differences between secured and unsecured loans that borrowers should be mindful of.  Since the money in an unsecured loan is not, in essence, supported by the right to seize the property in case of default, the interest rates on them are typically higher.

The lender in that case is taking a bigger risk, and they are rewarded by charging larger interest.  That covers losses from nonpayment (which are higher on unsecured loans) and is one way to alter borrowers’ incentives.  Nearly everyone will more effort to meet a debt that is coupled to their home over an unsecured loan.

So, there are advantages and disadvantages for both borrower and lender to obtaining one type of loan over the other.  As a borrower, you may find it essential to take a higher rate of interest if you don’t have a house, bonds or other assets to offer as collateral.  Or, you may just want not to put those at risk.

Only you can make a decision in your particular situations whether the benefits outweigh the risks and costs.