Difference Between Secured and Unsecured Loans

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What's the Difference Between Secured and Unsecured Loans

By Corey Landis

This sounds like a fairly simple question but it is not quite so simple to answer and in trying to do so you need to view the answer from the perspective of both the borrower and the lender.

In simple terms a secured loan is a loan which is granted on the understanding that if it is not repaid an asset will forfeited to the lender. This is the principle on which pawnbrokers have operated for many years. You take your late father's gold hunter pocket watch to the pawnbroker who assesses its value at $1,000 and lends you this money at an agreed monthly interest rate. You then pay this interest each month and, when you are in a position to repay the loan you do so and recover your watch. If however you fail to make your monthly interest payments and do not recover the watch the pawnbroker is then free to sell it to recover his $1,000.

Another common example of a secured loan is a mortgage. At the time the lender grants you your mortgage you lodge the deeds to your property with him as security until the loan is repaid. Just as with the pawnbroker, if you fail to make payment on your mortgage the lender then has the right to simply sell your property to recover his money.

Now of course in practice things are not quite that simple and no lender is going to take the decision to sell your home out from under you lightly. Apart from the fact that in reality selling your house would often involve the lender in a long, complex and costly battle, it is not a step which any lender ever wishes to take. That is not to say that lenders will not take this route if they have to and indeed repossessions take place up and down the country every day, but it is not a path which any lender willingly follows.

An unsecured loan by contrast is not backed by any form of security and is made by the lender on his judgment and against the borrower's past credit history in the simple belief that the loan will be repaid. In reality however the lender does have some limited security in that he can apply to the courts for the legal right to seize the assets of the borrower (including such items as his salary, stocks and other real property) should the borrower default on the loan.

The legal process is not however always easy and is not without cost so, once again, lenders are loath to follow this course of action unless they really feel that they need to do so.

Against this background it might seem that there is very little difference in reality between a secured and an unsecured loan. However, this is not the case.

Because, in theory at least, an unsecured loan is not backed by the automatic right to seize assets the lender is taking a greater risk in granting such loans and so the interest rate charged is generally higher. This is done not simply to cover the higher losses from defaults on unsecured loans but also in an effort to provide an incentive to borrowers to take out secured rather than unsecured loans. This is in the best interest of the lenders who know that people will make a greater effort to meet payments on a secured loan, particularly when that loan is secured on their home.

As a borrower you and only you can decide which type of loan will suit you best. Of course if you do not have any assets to offer as collateral then the choice is made for you but, where assets are available, you must decide whether you would prefer to offer them against the loan or pay a higher rate of interest for an unsecured loan.