What Is a Secured Loan?
There are two primary types of loans: secured and unsecured. An unsecured loan is a loan without collateral and it may include student loans, credit cards, and personal loans. Secured loans have collateral attached. The most common types of secured loans are car loans and mortgages. With this type of loan, your collateral will be at risk if you default on the loan, which means your lender can repossess or foreclose on the property.
A secured loan can offer a better interest rate than an unsecured loan as the lender has recourse if you don’t keep up with payments. It can also give you access to a loan if your credit is less-than-stellar. Still, it’s important to understand the consequences of taking out a loan secured by property.
Benefits of a Secured Loan
A secured loan is typically the best and only way to secure a very large loan because lenders are not likely to extend large amounts of money without good assurance that the loan will be repaid.
Compared to unsecured loans, a secured loan usually offers:
- A lower interest rate. This is because the loan has less risk than an unsecured loan.
- A higher borrowing limit. With a home loan, you can usually borrow 80% or up to 100% of the value of the collateral.
- Longer repayment term. Because the lender has recourse if you default and the loan amount is likely larger, you can more time to repay the loan.
Home Equity Loans Are Secured
When you buy a home, the mortgage is secured by the property. Home equity loans and lines of credit (HELOCs) are also secured. To access the equity in your home without selling the property, you are essentially taking out a second mortgage.
Most lenders attempt to ensure a home equity loan or HELOC is fully secured, which means the value of the home is enough to cover the first and second mortgages. This ensures that, if you default on either loan, a foreclosure sale will help both lenders recover the delinquent amount. This doesn’t always work out. Second mortgages always come after the primary lien or mortgage on the home, which is always paid first. In case of default, second lien holders do not always get paid if the home has reduced in value.
Don’t assume that your home is safe if you make on-time payments on your primary mortgage but fall behind on a home equity loan. The second lender can still pursue foreclosure because the loan is secured by the equity in your home.
Unsecured Debt Can Become Secured
If you take out a second mortgage, it can be used to convert unsecured debt to secured debt. Many homeowners do this unintentionally by taking out a home equity loan and using it to pay off high-interest credit card debt or other bills. While this can help you dramatically reduce the interest you pay on these debts, it comes with a big risk.
If you default on credit card debt, you will face damage to your credit rating and, in the worst-case scenario, a lawsuit or judgement. When the debt is paid off with a home equity loan, it now becomes secured by your home. If you do not keep up with payments, your lender can now pursue a foreclosure on your home. Home equity loans also tend to have long repayment periods which can leave you paying off the debt for a decade or longer.