What is a Secured Loan?
Where the borrower of the loan pledges his/her assets as a collateral to the issuer as a security, it is known as secured loan wherein the issuer of the loan has all the rights to sell or transfer the secured property to recover the balance due in case of nonpayment of the loan, where secured asset included various valuable asset of the borrower like house, land, car, gold, working capital asset, etc and it is generally issued to those entities and organizations that have lower creditworthiness.
As you already know, a secured loan is a loan that is backed by an asset or equipment. The asset is called collateral. This collateral is needed because the amount of loans in the case of a secured loan is much higher. This collateral helps the lender remain secured during the process of receiving the loan amount. And that’s why it is called the secured loan.
It is backed by an asset. That’s why the lender has no worries. Even the amount is huge. As a result, the lender accepts an interest rate that is much lower than the unsecured loan.
Let’s take an example to illustrate this.
Let’s say that you want to take a house. So, you go out and contact a bank and ask for a housing loan. The bank says that they will give you the housing loan without any issue, but there’s only one condition. The condition is you need to keep the house as collateral to the bank until the loan amount and the interest charges are paid off in full. Bank also says that as you’re accepting their offer, they will also offer you a reduced interest rate that is much lower than an unsecured loan.
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You happily agree and go for the housing loan and buy your dream house. This is how it works.
What happens when the borrower of the secured loans defaults?
Let’s take another example to illustrate the status of the lender and the borrower if the borrower defaults.
- Let’s say that Mr. M has taken a housing loan from a bank. Things are going pretty well. Mr. M has got the house and paying off the loan in installments.
- Now, suddenly Mr. M gets laid off from his job and feels overwhelmed since now Mr. M doesn’t have any money to pay off the housing loan.
- In this situation, a bank will come to Mr. M and declare that they will possess his house. Bank does a valuation of the house and notices that the market value of a house isn’t enough to pay off the entire loan.
- So the bank sells off the house and asks Mr. M to pay the difference.
From this, we can see the status of the lender and the borrower. In the case of secured loan, the lender is always at a better position than the borrower because they know that they can sell off the asset if the borrower defaults and at the same time they can claim the difference from the borrower if the market value of the asset isn’t enough to pay off the loan.
Important features of the Secured Loan
Let’s look at the most important characteristics of these loans –
- Asset backing: In every secured loan, the lender gets backing of the asset. As a result, a loan from the lender side becomes secured.
- Lower interest rate: Since the loan is backed by the asset, the interest rate is much lower. As a result, the borrower pays less interest in the case of a secured than in the case of an unsecured loan.
- Huge amount: These loans are usually huge in amount. If the amount is not huge, why the borrower would be ready to share his property for the collateral? In the case of a secured loan, the amount of loan that’s why is much larger than an unsecured loan.
- Loan against the same thing the buyers are buying: Usually, the borrowers of secured loans are those who are also buying a property. And in most cases like housing loans, car loans, auto loans, the buyers let the lender use the house, the car, the auto respectively for securing the secured loans. This arrangement helps the buyers buy the asset/equipment easily and at the end of the day, the lender also remains secure.
- Secured business loan: In the case of business, the conditions of these loans are a bit different. Since the businesses have more money to pay off, the loan amount is usually higher than housing loans, car loans. And a business lets the bank/financial institution use one of their assets/machinery/furniture/raw materials as collaterals for the loans.
This has been a guide to Secured Loans. Here we discuss its definition, examples. We also discuss features of secured loans and what happens when a borrower defaults. You may also learn more about fixed income from the following suggested articles –