Secured vs. Unsecured Loans - What Everyone Needs to Understand

From the beginning, both the lender and the borrower are faced with one basic objective - to get a loan that’s either secured or unsecured. But, what does that suggest, and what are the arguments of each for either party?

A secured loan is the type of loan in which the money borrowed is sure to be paid back or some asset will be forfeited. A common example is a car loan. The borrower agrees to reimburse on the terms of the contract, and if she or he defaults, the bank can legally claim the car as payment. In principle, that suggests that if you skip a payment on the car loan, the bank has the right in law to repossess the vehicle and then sell the property.

In practice, this is usually not a common occurrence. Among other reasons, banks know that reclaiming a the car can be a long, unpleasant process - trying to locate and forcefully remove your car from your possession can be difficult. Plus, the lender is left with a car that usually has lost some of its value and may not be what it was worth when they actually loaned you the money to buy it, and the necessity to sell that car to try to recoup some of that money.

No lender is intending to do that for such a little misstep as missing one payment. Whether or not the borrower lags on for many months,  the bank will usually send a chain of firm letters demanding payment before taking any other action. And in most cases, you will have to behind on several payments before they will consider taking action to repossess your vehicle.

Nonetheless , it’s sensible to understand that the bank has this right. How critical or not that right is can be judged by recognizing that even with an unsecured loan, creditors have the right in law to seize assets like income, stocks, and property.

The undertaking is a relatively easy and cheap legal process to declare the borrower in default. Legal procedures are only relatively easy and inexpensive, so lenders will almost always try and work out a repayment option before taking that step.

There are more differences between secured and unsecured loans that borrowers should be conscious of.

Since the money in an unsecured loan isn’t, in principle, backed by the legal right to seize the asset in the event of default, the fees or interest rates on them are generally higher. The lender in that case is taking a larger risk, and they’re compensated by charging higher interest. That covers losses from defaults ( which are higher on unsecured loans ) and is a method to change borrowers inducements.

This is the reason why most payday loans carry a higher interest rate than traditional loans, as they carry the highest risk of all unsecured loans. Not only are the loans not backed by an asset, but most payday lenders do not run a credit check and only have a few requirements for approval. This makes payday loans the more risky for the lenders who provide this service.

Most people will try much harder to meet their obligation to a debt that’s tied to their car or home than for an unsecured loan. So, there are arguments for both borrower and bank to getting one kind of loan vs the other. As a borrower, you may find it necessary to incur a higher rate of interest if you don’t have a home, a car, bonds, or other assets to offer as collateral.  Or, you may simply not feel comfortable with putting your possessions in jeopardy. For short term financial issues, payday loans are a great option in this regard. In the end, only you can decide in your special circumstances whether the benefits outweigh the risks and costs.

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