How To Understand Secured Debt

In the lending business, there are two forms of debt.  Unsecured debt is a loan or line of credit issued to a borrower without any collateral.  Credit cards are the most common form of unsecured debt in America today.  Most households have at least one credit card, many have two or more.  Since the lenders have no recourse against borrowers who default on their loan except legal action, they charge higher interest rates to offset the risk.

Secured debt is a loan or line of credit where the borrower offers the lender collateral to guarantee the loan.  If the borrower defaults on the debt, the terms of the loan grant the lender the right to seize the collateral and sell it to recover their losses.  Home mortgages and car loans are the most common forms of secured debt.  Another form of secured debt is a pawn shop loan.  People bring in valuable goods such as tools, TVs or stereo equipment.  If the debt is not repaid or extended within the time limits of the loan, the borrower forfeits the pawned items and the pawn shop sells it to recover their losses.

This points out the main difference between secured and unsecured debts.  With secured debts, the borrower has to consider the effects of the loss of collateral on their lives.  For example, if a person buys a car with a car loan and then loses their job, will the repossession of the car hurt your ability to find a new employer?  If the loss of the car would cause more hardship than making the payments with the reduced income, then continue to make the payments even if it means dipping into savings or selling off other household items until a new employer is found.  On the other hand, if making the car payments would interfere with the ability to make home mortgage payments, then letting the car payments stop to avoid foreclosure makes more sense.

Planning before the secured loan is applied for is very important.  Borrowers should sit down and make a budget of all their monthly expenses.  Then add in the payments of the prospective secured loan payment to see if the budget is still manageable.  If not, consider changing the terms of the loan or forgoing the purchase until finances improve.

In summary, secured loans are better for borrowers since the interest rate is lower.  Borrowers just need to keep them within their means to repay it.