A secured loan, is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan.
Secured debt is debt backed or secured by collateral to reduce the risk associated with lending, such as a mortgage. If the borrower defaults on repayment, the bank seizes the house, sells it and uses the proceeds to pay back the debt. Assets backing debt or a debt instrument are considered security, which is why unsecured debt is considered a riskier investment.
There are two primary ways a company can raise capital: debt and equity. Equity is ownership and implies a promise of future earnings, but if the company falters, the investor may lose her principal. Lured by the prospect of better growth opportunities, investors in equity have the implicit backing of the company but no real claim on company assets. Indeed, equity holders get paid last in case of bankruptcy. Debt, on the other hand, implies a promise of repayment and has a higher degree of seniority in the case of bankruptcy. As a result, debt holders are not as concerned about future earnings as they are about liquidation value. Within the world of debt, there is one particular class of securities that has a higher seniority than unsecured debt vehicles: secured debt vehicles.
In general, lenders are more concerned about the value of company assets than earnings quality because in the case of earnings decline, the company can sell assets. This is the informal course of action when firms are facing bankruptcy; however, some debt is contractually backed by specific assets. This debt is referred to as secured debt. Secured debt is a formal contract backed by assets that can be sold as collateral if the firm defaults on the loan. Due to its low risk profile, secured debt is favored among those companies with poor credit. Secured debt allows the borrower to shift the lender’s focus to the liquidation value of assets rather than the borrower’s creditworthiness.
The most commonly cited example of a secured loan is a mortgage. Other examples include the service provided by pawn shops or the factoring of receivables. Pawn shops give the borrower a loan based on the value of whatever that borrower is willing to pawn. In this way, secured debt is at the foundation of the pawn shop business model. Many firms also make a habit of receiving funding through the financing of accounts receivable. If the company cannot make the payment, the lender can use customer receipts and promissory notes to secure repayment. Other examples include car loans and home equity lines of credit, also referred to as HELOCs.
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