Borrowers can obtain many different types of loans from financial institutions that provide them. All of these loans will fall into two general categories, secured or unsecured loans. Some specific types of loans will always be secured, such as mortgages.
However, most other types may come in unsecured options as well. Ultimately, whether a loan is secured or unsecured depends on the type of loan required by a borrower and the financial institutions offering them.
A secured loan is a type of loan that requires the borrower to offer an asset as collateral to obtain the loan. Sometimes, the financial institution or the type of loan will also specify the class of asset that the borrower needs to provide, for example, a car or house.
In other cases, the borrower has the choice to provide any asset that is acceptable to the lender. The asset offered as collateral still belongs to the borrower. However, in case of default, the lender gets the right to dispose of the asset, to recover the loan.
Secured loans are simple to understand. When a borrower requests a loan from a lender, the lender requires the borrower to provide an asset as collateral.
Lenders need secured assets for several reasons, including most prominently to decrease risks associated with default. For unsecured loans, the borrower is at a significant advantage as defaulting on the loan won’t be as costly as compared to secured loans.
On the other hand, with a secured loan, the borrower loses the asset provided as security, thus, increasing the risks for the borrower as well.
Once the borrower provides an asset as security, the lender will put a lien over it. It allows the lender the legal claim to the asset in case of a default. The lien stays intact as long as the loan stays active.
In other terms, the lender will withdraw the lien when the borrower fully repays the loan. When the lender lifts the lien, the borrower receives back the legal right to the asset.
If the borrower cannot repay the loan, the lender can claim the secured asset legally. Usually, the lender will auction the asset to recover the amount of the loan.
Types of Secured Loans
As mentioned above, there are many different types of secured loans that borrowers can obtain. The type of the secured loan mainly depends on the asset provided as a backing to the loan.
1) Mortgage loan
The first and most common type of a secured loan is a mortgaged loan. In a mortgage loan, borrowers offer their houses as security.
In case of a default, the borrower loses control over the house, and the lender can put it up for auction. This type of secured loan is riskier for the borrower as the asset involved is more valuable.
2) Vehicle loan
As the name suggests, in this type of a secured loan, borrowers put their vehicles, usually their cars, as collateral. Other types of vehicle loans may also include motorcycle and boat loans.
Similar to mortgages, in case of default, the borrower can lose control of the vehicle. This loan can be less risky as the value of vehicles, while still a lot, is not as high as a house.
3) Credit cards
While credit cards are generally unsecured loans, some credit cards require security. Usually, borrowers with no credit history need to provide an asset as security to obtain a credit card.
However, instead of requiring a house or a vehicle like the above two types of secured loans, secured credit cards require a cash deposit as security. In case of default, the borrower loses the cash deposit to the lender.
Advantages of Secured Loans
There are many advantages of secured loans, to both the lender and the borrower of the loan. First of all, for borrowers, offering an asset as security allows them to obtain a loan without any complications.
It is particularly useful for borrowers who have a bad credit history and cannot get unsecured loans. Similarly, it allows borrowers to receive a loan at a lower interest rate as compared to unsecured loans.
For the lender, a secured loan helps them in mitigating the risks of default of the loan. In case of default, the lender also has a way to recover the amount of the loan.
Disadvantages of Secured Loans
There are also some disadvantages of secured loans for both the parties involved. First of all, for the borrower, a secured loan is riskier.
It is because, compared to an unsecured loan, the borrower faces the potential of losing the asset. Similarly, secured loans also mean if the borrower does not have any assets to offer as collateral, they will not get the loan.
For the lender, while secured loans are less risky, they do not eliminate the risk of default. Similarly, the value of the asset may change during the loan period due to external factors, so the lender may not completely recover the value of the loan.
Secured loans are loans in which the borrower provides an asset as collateral. The lender puts a lien on the asset, which gives them a legal claim over it. In case of a default, the lender can sell the asset to recover the value of the loan.
There are several types of secured loans based on which asset the borrower provides as security. Secured loans can have advantages and disadvantages for both lenders and borrowers.