A secured loan is one where you pledge an asset to serve as collateral to “secure” the loan to borrow a larger amount and receive a lower interest rate.
A lender may require the borrower to pledge a personal asset to back the loan in cases where their credit score and overall financial health disqualify them for financing.
The lender’s policy may also dictate that the borrower must designate a personal asset as collateral, regardless of their financial standing.
This requirement typically accompanies large loans issued to borrowers to buy a specific property or asset such as a home or car.
How Do Secured Loans Work?
You can obtain a secured loan from traditional lenders, such as the Big Five banks and credit unions, as well as a wide range of other financial institutions.
The lender will perform a credit check on you and assess your credit score as part of the application process.
They may also verify your income and evaluate your current debt load to ensure you can handle the loan payments.
Before the lender finalizes your loan, you’ll have to designate a personal asset as collateral for the loan.
The asset functions as insurance for the lender; they can sell it to cover any lost income if you default on the loan.
Supplying an asset to back the loan reduces the lender’s risk in extending credit to you.
As a result, you’ll generally gain access to lower interest rates and increase your borrowing capacity.
Secured loans come with fixed and variable interest rates, though the former is more common.
As part of your agreement, you must repay the principal and any interest charges according to a pre-determined payment schedule.
Types of Secured Loans
1. Mortgage loan
A mortgage loan is used to finance the purchase of a home.
For most borrowers, it’s usually their most significant financial commitment.
Mortgage loans come with fixed and variable rates and can take an exceedingly long time to pay off (think 20 years or more).
Given the loan size and risk posed to the lender, a mortgage contract requires all homebuyers to list their home as collateral.
A home inspection and appraisal are often necessary to secure financing.
2. Home equity loan
A home equity loan enables you to leverage the equity in your home as collateral to acquire financing for a loan.
If you successfully apply for a home equity loan, your lender will provide you with the entire principal upfront.
The loan will have a defined term length, and you’ll pay a fixed interest rate.
3. Auto loan
The purpose of an auto loan is to help you finance the purchase of a vehicle.
As a precondition for approval, you’ll have to pledge the vehicle you intend to purchase as collateral.
Auto loan terms generally range from 3 – 7 years, and most have a fixed rate.
4. Business loan
A business loan is used to finance a wide assortment of capital investments needed to start and operate a company.
These include equipment, buildings, vehicles, and inventory.
The lender and borrower can arrange for specific types of assets to secure the loan:
General security agreement: lender has a legal claim to all assets, excluding land and buildings.
Collateral mortgage: lender has a legal claim to land and buildings
Personal guarantee: lender has a legal claim to the borrower’s personal assets
5. Secured credit card
A secured credit card works like any regular credit card except that you must place a deposit with your lender to use it.
Typically, the size of your deposit determines the credit limit for the card.
If you default on your payment obligations, your lender will close your account and collect the deposit to cover their loss.
Many other types of secured loans are available, each catering to a specific need.
These include boat loans, recreational vehicle loans, life insurance loans, bad credit loans, title loans, and more.
What Assets Can I Use to Secure My Loan?
Each lender has its policy regarding what assets qualify as security for a loan.
In many cases, a secured loan is tied directly to the asset you purchase using the loaned funds.
For example, let’s say you use the loan proceeds to finance the purchase of a specific and tangible asset, like a home.
In that case, your home will serve as collateral.
The same concept applies to a car loan or car title loan – the vehicle you purchase will function as security for the loan.
With a business loan, you may have to pledge your equipment, land, buildings, accounts receivable, inventory, and personal assets for security.
Suppose you apply for a secured loan with no clearly defined purpose for using the funds.
In that case, investments you own like stocks and bonds can function as collateral.
For secured loans issued by pawnshops, the lender may accept a wide range of personal assets as collateral, such as jewellery, artwork, and electronics.
Did You Know?
In Ontario, a common way for a mortgage lender to take possession of a home is through a Power of Sale. As part of the deal, the homeowner keeps the excess profits resulting from the sale of the property.
Pros of Secured Loans
Here are the main benefits of secured loans:
- Lower-interest rates: Because your asset provides extra security for the lender, they’re more willing to offer you a discounted rate.
- Higher borrowing capacity: You may have the opportunity to borrow a vastly larger sum than if you opted for an unsecured loan.
- Longer terms: Since lenders assume less risk by issuing you a secured loan, you may qualify for a longer term, which will translate to lower monthly payments.
- Available for borrowers with bad credit: Do you possess a poor credit score? If so, pledging a personal asset as security will allow you to bypass lenders’ typical credit score requirement.
Cons of Secured Loans
Despite the numerous benefits, secured loans have some shortcomings.
- Personal asset(s) at risk: If you default on a secured loan, your lender can legally repossess your asset and sell it to cover their loss.
- Less flexibility: You may face restrictions limiting what you can purchase since the loan may be tied to a specific asset. For example, with an auto loan, you may only use the funds to buy a vehicle.
- Longer application process: Your lender must verify and appraise the asset that will function as security for the loan. As a result, be prepared to fill out more paperwork and possibly endure a lengthy application process.
What Happens If I Default on a Secured Loan?
Should you default on a secured loan, your lender can take possession of the asset that serves as collateral.
There is usually a lien on the asset, which means that you won’t be able to sell it until you settle the outstanding debt.
Suppose your lender believes there’s no possibility of you repaying the loan.
In that case, they can sell your asset and use the proceeds to cover the outstanding loan balance.
Defaulting on a secured loan will adversely impact your credit score. A repossession can remain on your credit report for up to seven years.
Frequently Asked Questions
- What is an example of a secured loan?
One of the most common types of secured loans is a mortgage.
When you apply for mortgage financing, the home you purchase serves as collateral for the mortgage.
If you miss too many payments for an extended period, your lender can legally place your home in foreclosure. This means they’ll take possession of it and sell it to recoup the mortgage balance owing to them.
- Is a secured loan a good idea?
Obtaining a secured loan may or may not be a good idea. It entirely depends on your financial circumstances.
Secured loans are ideal if you’re looking to borrow a significant sum of money at a low-interest rate. They’re also an excellent way to get financing if you have poor credit.
However, your lender may repossess the asset(s) you’ve designated as collateral if you encounter financial trouble and default. As a result, you should avoid secured loans if you lack a stable income or are unwilling to accept the risk of repossession.