Explanation: When a borrower’s asset is used as collateral, it is pledged as security for that transaction. In other words, if the borrower does not make the payments as agreed upon in the loan agreement, the lender can take steps to secure or repossess (take ownership) of the asset. In this way, the loan is said to be “secured” to the asset. Foreclosure is a form of repossession, but it is a considerably more complex and involved process (as it should be) because it involves a borrower’s home. Just how complex, however, depends upon the laws in the state where the home is financed.
- Secured Loan
- Any loan that requires collateral from the borrower in order to be approved and funded by the lender.
+ Pros: Typically, easier lending guidelines and higher loan / credit limits are available than with unsecured forms of credit, credit cards and unsecured personal loans. In addition, rates offered are generally lower. Ultimately, the rate offered (if you are approved) will depend upon several factors, including the type of lender, collateral, credit and income history, lien position (see below) and amount borrowed.
– Cons: The time from application to approval can be considerably longer, as the pledged asset is typically verified, inspected and documents are recorded (if required). More important, however, is that the borrower’s collateral is put at risk. For example: Lower payments can be a great stress reliever. But, If you use your home to secure a debt consolidation loan, and then lose your job, imagine what your stress level will be like then. As with all personal finance decisions, be sure to consider the potential long-term consequences, not just the short-term benefits of the transaction.
Additional Details: Secured loans are categorized by the type of collateral used for the loan.
Some common examples of secured loans include:
Home Loan – Home purchase financing, mortgage refinance and home equity loans. This type can be subdivided further. A few of the common groupings are below.
- Lien Position: First or Second. A lien position is the priority (or position) that the lender has on a house. For example, if you bought a home and financed it with a 30 yr loan from a mortgage company, the company would be in the first lien position. If, at a later date, you also took out a home equity loan from a bank, that bank would be behind the first mortgage, thereby having second lien position. Home equity loans can be a first or second mortgage depending upon whether the initial loan has already been paid off.
- Interest Rate Structure: Adjustable or fixed rate loans. A home mortgage loan can gradually adjust to market conditions with annual, as well as life of the loan, caps (limits), or simply be fixed at one, set mortgage interest rate for the life of the loan. Our current mortgage crisis owes a lot of its problems to adjustable rate mortgages that borrowers obtained at below market rates. When the economy soured and many homeowners suddenly found themselves out of work, many borrowers weren’t able to handle the payments, let alone any adjustment in their mortgage rate. The choice of whether to go with adjustable rate mortgage financing is not something that should be taken lightly. Are you willing to risk the ownership of your home in exchange for a potential tax break and a short-term reduction in your payments? Mortgage lenders are required to make sure that borrowers have the ability to repay the loans they apply for, but only you know your entire budget and what you can truly afford. Never take out an adjustable rate loan unless you are prepared (and able) to make payments based upon a rate that has adjusted upwards.
- Loan Term Variations: Closed (fixed) or open. A loan agreement can be structured to be paid off in a set period of time, such as with 30, 20 and 15 year terms, or be open-ended like a home equity line of credit, which is commonly used for debt consolidation, home improvement, medical and other expenses. The word open can appear to be a little misleading, as home equity lines are usually set up to be drawn on only for a set period of time. Once this period expires, they may convert to a fixed loan until the balance is paid off. These types of loans are almost always structured with an adjustable interest rate. In most cases, this rate is offered with a very low introductory, or teaser, rate. Don’t fall into the trap. If you are currently considering this type of loan option, make sure that you first read the paragraph directly above and understand the risks that go along with an adjustable interest rate.
- Auto / Car Loan: Most often for purchase, and occasionally for refinance. In addition, to financing the vehicle alone, sometimes loans for other purposes may be secured against an automobile. (see below) A car loan may seem to be a good alternative to using your home’s equity for consolidating debt. However, what if you borrow against your primary (or only) vehicle and count on it for transportation to and from work? If you cannot get to work, everything you own that is secured with a loan is suddenly put in jeopardy. Also, keep in mind that repossessing a vehicle on a defaulted loan is considerably easier for a lender than foreclosing on a residence. An auto loan to consolidate debt may not necessarily be a bad option for you, but make sure that you thoroughly understand the risks before moving forward.
- Secured Personal Loans: This type of financing isn’t as common as it once was, but typically when a personal loan requires collateral, an automobile will be used. You may also hear this referred to as a title loan. In the past, finance companies were known to use virtually anything (legal) as collateral. However, this type of lending is not to be confused with pawn loans, like those you may have seen being made reality television shows. A pawn loan is a different type of loan arrangement and is for a short term. Whatever the initial intent, however, the item pawned often becomes the property of the shop and is ultimately put up for sale.
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