The Great Divide: Secured vs. Unsecured Loans
Personal loans come in two distinct flavors and the one you choose will make a big difference in how much you can borrow and how much interest you pay.
Flavor No. 1 is known as “secured loans” and is safest for the lender since it contains a built-in backstop. Secured loans require that the borrower have collateral that can be repossessed if the borrower defaults. These are among the most common loans made. Home mortgages and car loans are secured and so are items people pawn in exchange for cash.
The other flavor, “unsecured loans,” are even more common. They don’t require collateral, so the lender is taking a very high risk. He’s accepting the word of the borrower that the loan will be repaid. If the borrower defaults, the lender might try to have the borrower’s wages garnished, but otherwise it’s hard to collect a debt.
Credit cards and student loans are unsecured borrowing. With credit cards, you can buy things today as long as you repay the card issuer when you get a bill. If you don’t repay the full loan when the bill is due, high interest rates on the unpaid balance generally kick in and it becomes very costly for the borrower. Student loans that go into default become a permanent negative mark on a consumer’s credit report, until the consumer resumes regular payments.
Lenders tend to be cautious in making both secured and unsecured loans. Repossessing a car or foreclosing on a house can take time, and the condition of the collateral is never certain, so lenders want to know a lot about a borrower’s income and credit history before issuing a secured loan. Unsecured loans are a bigger problem, since repayment is just a contractual obligation. For that reason, the size of unsecured loans is often much smaller than secured ones and the amount of interest charged on balances due is usually much greater.
Each flavor has its own customers. Home mortgages can be very large and take up to 30 years to repay. Credit card debts, by contrast, are unsecured loans that are generally repaid each month, or over relatively short periods. Home loans allow you to buy something expensive that will increase in value over decades. Credit card borrowing helps you buy necessities or pay for everyday expenses with the understanding that you’ll return the borrowed cash when the monthly bill arrives.
The good news is that when used correctly, secured and unsecured loans can be a boon to your finances, allowing you to buy big things that cost far more than you’ve saved and small things much more conveniently than if you needed to pay cash or write checks.
The bad news is that people often don’t use loans correctly or end up in situations they didn’t predict and that make repayment difficult.
Let’s consider what it takes to borrow wisely and what to do if problems arise despite your best efforts.
Secured loans are the backbone of the housing and automobile economy. Without home mortgages, very few people would be able to afford America’s real estate prices. And most would balk at new car prices since they don’t keep large reserves of cash in their bank accounts.
Secured loans make big ticket items affordable. Better still, the ability to seize the item being purchased if the loan goes into default makes these loans desirable for lenders. Security lowers risk for the lender, and helps keep interest rates down.
Housing loans are normally considered good debt. Lenders will want to know a lot about you and the value of the real estate you’re buying for two reasons: They want to feel confident you will be about the repay a big loan for 10 to 30 years and they want to know that if you don’t, the can take your house and sell it to cover the debt.
Car loans tend to have higher interest rates than home loans because the value of the collateral – your car – decreases with time. A lender can seize the collateral, but it might not be worth enough to cover the loan. A higher interest rate helps offset the risk of that happening.
Unsecured loans lack collateral, which for lenders is a huge drawback. The inability to seize an asset if a debt goes into default leaves lenders’ money vulnerable, and millions of borrowers with unsecured loans bring that point home every day.
Credit cards are the biggest source of unsecured borrowing. More than 160 million U.S. households use credit cards with an average debt of $16,662 per household. The nation’s total credit card debt is exceeds $764 billion.
Though on-line lenders, often called peer-to-peer lenders, and banks make unsecured personal loans, credit cards dwarf them. In fact, most consumers with debt problems fall into the trap through unsecured borrowing. Illness and job loss also cause major problems, but even these are made worse if the unfortunate person has a lot of consumer debt tied up in credit cards.
Lenders can’t seize an asset to compensate for an unsecured debt gone bad, but they can put a lot of pressure on borrowers. Garnishing wages is one way they can collect unpaid debts. Even if a debt goes uncollected, the borrowers in default likely will find it hard to borrow money at a reasonable rate for years to come. When consumer debts fall in arrears, reports are filed with the nation’s three large consumer-credit rating agencies, resulting in the borrowers’ credit scores dropping. The lower one’s score, the harder it is to get credit and the more expensive that credit is.
Even those who don’t default or fall behind on their credit card debts can damage their scores by carrying large balances. In financial-speak, the percentage of your credit line in use at any time is called you credit utilization. If your utilization is too large – generally considered to be 30% or more of your credit limit – it will weigh negatively on your credit score.
Getting Help with Secured Loans
If you run into problems paying monthly installments on your car or house, help is available. Don’t wait until you are already in default before acting.
Having your car repossessed can happen quickly if you fail to pay your loan, so it’s important to do whatever you can to remain current with your payments. Laws vary from state-to-state, but if you violate the terms of your loan agreement, lenders can repossess your car without notice.
Review your car loan agreement to learn what it takes to be found in default. Some agreements give you a 30-day grace period to make your loan current. Others require written notification from the lender before your car can be repossessed. If you fall behind because of a temporary financial problem and you have the money to bring the loan current, contact the lender to reinstate the loan.
If your car is repossessed, remember that you might owe more than it is worth. Lenders can go to court to request a deficiency judgment, which is a court order that requires you pay the difference between the car’s value and the amount you owe. To avoid this, try negotiating with the lender when you can’t make payments. Sometimes, if you voluntarily surrender the car, the lender will forego a deficiency judgment filing. Also, you can try to sell the car yourself if you think you can net enough to repay the loan.
Not paying a mortgage can have more serious consequences. If you fail to make payments, the lender will file a notice to foreclose. Failure to remediate the payment problem leads to the lender moving ahead with the foreclosure, which typically ends with you losing your home,
Foreclosure was a particularly common problem following the financial industry crisis of 2008 when real estate prices dropped dramatically in many markets. Borrowers found that they owed more on their hones – often far more – than their market values, and they tried to negotiate with lenders to exit their mortgages. Lenders often allowed short sales, where the owner sold the home for less than the amount owed and the lender agreed not to pursue a deficiency judgment.
For more information on the options opened to distressed homeowners, visit the federal Department of Housing and Urban Development website, www.hud.gov.
Debt Help for Unsecured Debt
Getting out of unsecured loan debt can be complicated. Often a debtor has defaulted on several credit cards and owes more than his or her income is capable of repaying. If that is the case, borrowers should contact the debt holder, usually the credit card company or a collection agency, to discuss options.
First, try to organize your finances to pay down your credit card balances. Focus on the cards with the highest interest rates first while making minimum payments on the rest. In order to reach your payment goals, go on a personal austerity program – brown bag lunches instead of eating out; cut the cord on cable TV, find a cheaper cellphone plan, cancel vacation plans and look for ways to trim your electric bills.
If that doesn’t work, the next-best solution could be a debt management program through a nonprofit credit counseling agency. The agency will work with credit card companies to reduce interest rates on your cards and design an affordable monthly payment. This process eliminates the debt over time – usually 3-5 years – and requires discipline and commitment.
The goal of these programs is to settle debts with the least damage to the debtors’ credit ratings. Often, they accomplish their goals, but sometimes the debtor is unable to resolve what is owed. Bankruptcy might be the only solution in such cases. Though bankruptcy can severely limit the filer’s ability to borrow money in the years ahead, it is sometimes the only way to clear off crippling debt.
Bankruptcy can discharge many personal debts, but not all. Student loans and child support are prime examples of non-dischargeable debt, meaning you are still obligated to pay them even after your other debts have been removed through bankruptcy.
Lane, S. (ND) Options to Avoid Car Repossession. Retrieved from: http://www.nolo.com/legal-encyclopedia/options-avoid-car-repossession.html
NA, (2012) Mortgage Assistance Guide, Retrieved from: https://portal.hud.gov/hudportal/documents/huddoc?id=MortgageAssistanceGuide.pdf