If you need to borrow money, a fundamental choice you have is between a secured loan and a non-secured loan. It is important that you understand what difference that choice would make in your situation, because it could affect both the cost of your loan and the extent to which you are putting valuable property at risk.
There is no easy answer to this question. It's not like secured loans are fundamentally good or bad - their merit depends a great deal on the situation. The more you understand the pros and cons of secured loans, the better you can decide whether one is a good fit for you.
What is a Secured Loan?
A secured loan is a loan backed by collateral, which is property of sufficient enough value to cover the principal of the loan should the borrower fail to repay.
However, the collateral does not always have to be the property the loan is being used to purchase. You may already have property you can use as security for a loan - often, this is property like a long-term investment portfolio or an art collection that you don't want to liquidate to simply make a purchase in cash. Instead, you would like to keep that property intact but use its value to borrow against for your new purchase.
From the lender's point of view, having that property as collateral makes them more confident in lending money. As a result, they should be more likely to make the loan, and to offer more favorable terms.
Risks to Consider About Secured Loans
Putting up property can help you get a loan, but this is not a decision to be taken lightly. Here are three things to consider first:
- Having property does not mean you can afford the loan. The issue here is having enough cash flow to make the loan payments. You may have some personal property worth $10,000 which can help you get a $10,000 loan, but the real question is whether your income and existing expenses will allow you to make the payments on the loan. If not, you risk forfeiting that property or having to liquidate it under unfavorable circumstances.
- Job security is a key variable. Looking at your current budget to see if you can afford the loan payments is important, but it is only a start. Loans are typically multi-year commitments, so you need to be confident that your income will continue to be enough to support the loan payments. This involves assessing your job standing at your current employer, the stability of that employer, and the marketability of your job skills should you have to make a change.
- The risk of losing your property is serious. If there is a reason you don't want to simply sell your property and use the cash now, chances are you won't want to be forced to sell that property later on to make good on the loan. That may entail losing property that is hard to replace, or having to liquidate an investment portfolio at an inopportune time. The lender may consider seizing the collateral as an acceptable fallback position should you default on the loan, but you should not view it as an acceptable outcome.
Why Secured Loans Can Work for You
The risks outlined above are serious considerations, but they do not mean secured loans cannot work out well for you. Here are three reasons it might be the right choice:
- It may be less expensive than an unsecured loan. Lenders use interest rates in part to compensate for risk. If you reduce the riskiness of the loan by securing it with collateral, chances are they will reduce the interest rate.
- It could help you build or rebuild your credit history. If you don't have much credit history or, worse, if that history is damaged, you may have trouble getting a loan without collateral. A secured loan might be a good start in building a favorable repayment history - if you make sure you keep up with those payments.
- Non-payment has pretty serious consequences anyway. Whether a loan is secured or unsecured, you should think through your ability to repay very carefully before you commit to the loan, because non-payment has serious consequences beyond just the seizure of collateral. Your credit rating is certain to take a hit, other forms of credit are likely to become more expensive or unavailable in the future, and you may face costly legal action. Just because a loan is unsecured does not mean there are not risks to defaulting.
What this comes down to is borrowing only when you have a good purpose for the money and have thoroughly examined your ability to repay. Those principles should apply to any loan, but the stakes are even higher with a secured loan.
Whether you choose a secured or unsecured loan, remember that different lenders are likely to offer different interest rate and fee terms for loans that otherwise seem identical. Some shopping around can make your loan decision as cost-effective as possible.