Secured Debt: Is It The Right Choice?
If you need a loan, you’ll want to understand the meanings of secured debt and unsecured debt. In some cases, secured financing may be your only option, particularly if you don’t have the best credit history. Here’s what you need to know about the advantages and disadvantages associated with these types of lending products.
What Is The Meaning of Secured Debt?
Secured debt means that you provide collateral that guarantees the loan in exchange for the money you receive. Collateral is assets that you own, such as your home or car.
For example, when you take out an auto loan, it’s guaranteed by your car. The lender places a lien on the asset you use as collateral and seizes it should you fail to make your repayments. If the asset is forfeited, the proceeds from any sale settle your debt. If the proceeds are insufficient, the lending institution can pursue you for the balance due.
A mortgage is another example of secured financing. In essence, your home guarantees your mortgage loan repayment. If you fail to make the payments, the bank or other lending company can take possession of your house. Home equity lines of credit (HELOC) is another type of example of this lending type.
If you don’t have the best credit score, you may be limited to applying for a secured credit card. These cards still qualify as revolving credit, but they’ll require you to make a security deposit.
How Is Collateral Related To A Secured Debt?
The most common forms of collateral used to obtain financing include:
- Real estate, such as your home, vacation home, or other property
- Precious metals
- Art and other collectibles
- Insurance policies
- Future income
No matter the type of asset you pledge to obtain the financing, the lender will first order an appraisal to determine the collateral’s actual value. For instance, when applying for a mortgage, the home’s appraised value has to be the same as the asking price, if not higher.
When you sign your lending product documents, you agree to forfeit the collateral. Thus, no legal action is required should you default on the arrear.
If you file for Chapter 13 bankruptcy and have secured debt, you have two choices regarding your assets. You can ask to keep your property, continue paying the regular monthly payments, and catch up on the balance owed through a trustee-managed repayment plan. Second, you can surrender the asset. If you opt for this direction, the collateral will be seized by the bank or creditor. It’ll then be sold and used to pay off your outstanding balance.
What Are The Pros Of Secured Debt Financing?
There are many reasons why you might prefer to apply for this type of financing:
- You can borrow a more considerable amount of money: Since the debt is backed with collateral, lenders feel more comfortable loaning more money
- Easier to get a loan: Your financial history is less important. You can have less than stellar credit and still qualify
- More affordable interest rates: These loans pose less risk to lenders. Therefore, they’re willing to offer a lower APR
- Build your credit: Taking out this type of financing can help you repair or build your credit
- Possible tax deduction: You can deduct the interest you pay on your mortgage and other individual guaranteed loans from your taxes
What Are The Pitfalls?
There are a couple of drawbacks associated with this lending type.
- You can lose your assets. The collateral you pledge to obtain the loan can be seized if you don’t make the payments. Creditors prefer that you pay and are willing to consider other options. However, ultimately they have the legal right to take the assets
- Getting money can take longer: Unlike an application for financing without collateral that can be processed quickly, underwriting this lending product requires time. Before you can obtain funding, the asset will be valued. If the lender’s estimate doesn’t necessarily match yours, it could require a bit more back and forth communication. Moreover, you may need to provide additional paperwork to prove its value as well
Which Is Better? Secured or Unsecured Debt?
Unsecured financing isn’t backed by collateral. However, this doesn’t keep your assets out of reach of lenders. If you fail to make the payments, the creditor can seek judgment against your assets, such as a lien on your property or wage garnishment.
Secured debt is better if you need to finance a more considerable amount of money. The financing can be more affordable because of the lower interest rate you obtain. However, there’s a risk. Unlike financing without collateral, no court action is required should you default. You agreed to the terms of repossession in the loan document.
The Bottom Line
There are other types of financing that fall into the definition of secured debt. Which kind of lending is best? It depends on your unique situation. Collateralized financing has many advantages, and it could be the best choice.
However, it’s less risky for the lender than it is for you since you could lose your collateral. Before making a choice, learn the pros and cons associated with the different types of lending products.