Secured loans are loans 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.
The opposite of secured loans is unsecured loans which is not connected to any specific piece of property and instead the creditor may only satisfy the debt against the borrower rather than the borrower’s collateral and the borrower. Generally speaking, secured debt may attract lower interest rates than unsecured debt due to the added security for the lender; however, credit history, ability to repay, and expected returns for the lender are also factors affecting rates. The term secured loans is used in the United Kingdom, while in the United States it is more commonly known as secured debt.
There are two purposes for a loan secured by debt. In the first purpose, by extending the loan through securing the debt, the creditor is relieved of most of the financial risks involved because it allows the creditor to take ownership of the property in the event that the debt is not properly repaid. In exchange, this permits the second purpose where the debtors may receive loans on more favorable terms than that available for unsecured debt, or to be extended credit under circumstances when credit under terms of unsecured debt would not be extended at all. The creditor may offer a loan with attractive interest rates and repayment periods for the secured debt.
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.
How to Create Secured Debt
Debt can become secured by a contractual agreement, statutory lien, or judgment lien. Contractual agreements can be secured by either a Purchase Money Security Interest (PMSI) loan, where the creditor takes a security interest in the items purchased (i.e. vehicle, furniture, electronics); or, a Non-Purchase Money Security Interest (NPMSI) loan, where the creditor takes a security interest in items that the debtor already owns.
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 secured loans are mortgages. 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.
Secured Loans examples
- A mortgage loan is a secured loan in which the collateral is property, such as a home.
- A nonrecourse loan is a secured loan where the collateral is the only security or claim the creditor has against the borrower, and the creditor has no further recourse against the borrower for any deficiency remaining after foreclosure against the property.
- A foreclosure is a legal process in which mortgaged property is sold to pay the debt of the defaulting borrower.
- A repossession is a process in which property, such as a car, is taken back by the creditor when the borrower does not make payments due on the property. Depending on the jurisdiction, it may or may not require a court order.
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