A secured loan may sound like the perfect solution to getting something you can’t afford to pay for with cash or to get out from under mountains of debt on high-interest credit cards, but you might be putting a lot on the line.

First, let’s define a secured loan.

A secured loan is a loan backed by collateral, which is a property pledge to insure repayment of a debt. The bank or other lender puts a lien on a piece of property equal or greater in value than the loan.

For instance, in the case of a car loan or mortgage, the car or house is the collateral. In other cases, a borrower puts their house up as collateral in order to get cash for home improvements, furniture, or even to pay off other debt. This is a called a Home Equity Loan or a Home Equity Line of Credit.

While a lender may not be willing to lend such large amounts of money through an unsecured personal loan, a secured loan decreases the risk to the lender. It sounds like the perfect solution to buying a new car, new home,  investment property, or even your child’s uni fees.

People often get secured loans for:

- Houses (in the form of a mortgage)
- Cars and other vehicles
- Certain business equipment, such as farm equipment
- Land
- Home improvements
- To pay off non-secured debt

Benefits to Secured Loans

Secured loans, because they are a lower risk to the lender, typically have much lower interest rates than personal bank loans. For someone carrying a lot of high-interest credit card debt, a home equity loan can consolidate credit card debt into one easy home equity loan that is paid every month.

Unlike the minimum payments on credit cards, a home equity loan payment does not change each month. The borrower will see their debt go down with each payment, and know there is a definite end to the loan. For many people, a home equity loan provides a way out of debt. For some, it seems to be the only way.

Drawbacks to Secured Loans

A secured loan protects the lender, but can put the borrower at great risk. In today’s economy, largely sparked by the mortgage crisis in the U.S., lenders all over the world (including Australia!) have become more conservative. They hesitate to give even secured loans to borrowers who don’t have a good credit history and can’t show the means to pay the loan.

Certain types of secured loans pose a greater risk than others, including:

- Debt Consolidation Loans
- Interest-only mortgages
- “Honeymoon” (Introductory) rate mortgages
- Split-rate mortgages
- Car Loans

Whatever type of loan, whether it’s a car loan, mortgage or debt loan, the risk to a secured loan is that if the borrower can’t pay, he loses the collateral. In the event of a car loan, failure to make payments can result in re-possession of the vehicle. If the vehicle is worth less than the amount of the loan, the borrower may lose their car and still owe the bank money.

In the event of non-payment of a mortgage or a home equity line of credit, a borrower may lose his house to foreclosure.

The greatest risk exists when someone takes out a home equity loan or line of credit against their house to pay off non-secured debt. With credit cards paid off, the borrower may begin using them again, creating an endless cycle of debt. As minimum payments on the cards grow larger, the borrower may not be able to pay his home equity loan, either.

Using your home as collateral to pay off debt may seem like a smart choice, but be careful. If it is the first step to a debt-free lifestyle, be sure to stay on that path.

Be careful with secured loans. They may seem like a good idea to get out of debt, but think about the collateral at stake if you can’t afford to pay.

Photo by benprks