Did you know that taking a loan could be easier if you have an asset securing the loan? For large expenses especially, it is prudent that you don’t max out your credit card. Putting up an asset as a guarantee for payments is less likely to harm your credit score or put you in a cycle of debt.
Secured loans could be a way to borrow the money you need. Read on to understand the intricacies of secured loans and how they work.
What is a Secured Loan?
When you take a loan from financial lenders, it’s usually on two grounds: secured or unsecured. You can secure the loan by pledging a valuable asset such as your home, car, or money if you default – also known as collateral. In contrast, an unsecured loan is where you take out a loan based on your previous credit score and without any collateral to secure the loan. Examples of a secured loan include;
- Home equity loan
- Auto loan (to buy a car)
- Personal loans, e.g., Car-title loan (your car as collateral)
How a Secured Loan Works
Secured loans allow you to borrow large amounts of money at a fair interest rate. For example, if you want to buy a home or a car, these are used as collateral until you pay the total amount owed on the loan. You can also use other items such as stocks, bonds, and personal property can also be used to back a loan. These items act as collateral where the financier can take possession of them and resell them, just in case of failure to pay the loan back. Of course, secured loans present a more considerable risk to the borrower and decrease the lender’s risk. Nonetheless, secured loans are easier to approve and can also be less expensive.
Examples of Secured Loans
Below are the most common types of secured loans:
A mortgage is a home loan. The house acts as a backup to secure the loan. If you forgo your payments, the loan goes into default, in which case the lender will foreclose on your home and sell it to recover losses.
A home equity loan is different from a mortgage in that the home’s equity acts as collateral. Home equity is the difference between the home’s market value and your current mortgage balance.
The security for this type of loan is the car, truck, or whatever automobile you want to purchase. However, similar to a mortgage, failure to pay back the loan can result in repossession of the automobile in question.
Secured personal loan
These are personal loans taken in exchange for financing. Here you can put various assets to secure the loan, including money, a vehicle’s logbook, stocks, bonds, jewelry, and other valuable personal items.
Advantages and Disadvantages of Secured Loans
Though taking a collateral loan can be an effective way to borrow money, some risks that hardly exist with other loans may present with secured loans. But first, let’s have a look at the major pros of a secured loan:
Advantages of Secured Loans
You stand a better chance for approval
If you’re struggling to get loan approval, perhaps due to a “less-than” credit score or a brief credit history, securing a loan with collateral can help improve your threshold for loan approval as a borrower.
Higher Borrowing Limits
With collateral, you’re essentially reducing the lender’s risk by offering up an asset. Effectively, this makes it easier to qualify for a higher borrowing limit than you would normally. Hence, many people opt for a secured loan for more significant amounts of money.
Better Repayment Terms
Secured loans often come with a more extended repayment period compared to their unsecured counterparts. For instance, most home loans allow a borrower upwards of up to 30 years repayment period.
Additionally, tying a loan to a valuable asset causes interest rates to be lower since the lender has reduced financial risk. The guarantee to financial institutions that they will get their money back, whether through monthly repayments or sale of the asset to recover potential losses, makes the terms less stringent.
Offers short-term liquidity
Suppose all of your cash flow is tied up in an asset that may take time and energy to convert into cash, such as a home or valuables. In that case, a secured loan can help you get liquid money without having to go through the demanding process of selling the asset.
Builds Your Credit
Fully repaying a secured loan on schedule will enhance your credit rating. In turn, this rating makes for better terms, such as lower interest rates the next time you’ll need to borrow.
Disadvantages of Secured Loans
You can Lose the Asset if you Don’t Pay back the Loan on Time.
The most significant risk of a secured loan is the chance that you could lose the asset if you’re unable to repay the loan. It’s particularly riskier if you place a precious asset like your family home to secure the loan.
Requires you to have a valuable asset.
Another potential challenge is that you must have something of value to offer as collateral. Unlike an unsecured loan, where you only need a credit score to qualify, secured loans can be limiting.
Some unsecured loans let you spend your loan on whatever you may wish. Specific secured loans such as mortgage and auto loans are usually tied to the collateral you’re putting up. A mortgage relates to your home, an auto loan relates to the automobile.
Secured Loan Alternatives
Though it can be much easier to borrow money if you secure the loan with an asset, you might not be comfortable risking your property. It could also be that you might not have any assets to consider as collateral. If that’s the case, you do have a few other options:
Unsecured personal loan
It’s possible to obtain a loan without securing it with collateral. An unsecured personal loan means you don’t have to back it with an asset. Instead, you simply sign a contract declaring that you will pay the loan back according to the conditions provided. If you don’t, your credit rating takes a hit, and it becomes challenging to get another loan from accredited lenders.
The main disadvantage of unsecured loans is the qualification requirements are often stringent, and interest rates tend to be higher since it’s a riskier loan for the lenders.
All is not lost if you can’t qualify for a secured or unsecured loan due to poor credit scores. For example, a credit-builder loan by a financial institution – usually a credit union – can deposit money in a bank account for you and hold it until the end of the loan term. You then pay the institution back for the deposit in installments. Once the time is over and you’ve managed to pay up, you get the money, and your credit activity gets updated to the credit bureaus for clearance. However, this type of loan does not guarantee immediate access to funds.
Are Collateral Loans Worth It?
Collateral loans come with the risk of potentially losing your asset upon failure to repay the loan on time. Still, if you have a plan to pay back the cash on time, it can be well worth it. Securing a loan with collateral reduces some risk since they typically come with lower interest rates and fees. This can save you a good amount of money in the long term. It helps if you have a specific goal for your secured loan, as well as a solid plan to pay it off.