What is a Secured Borrowing?
A secured borrowing is a loan or debt that’s backed by collateral. The interest rate on secured borrowing is lower than that on an unsecured loan. However, it can be a riskier option for the borrower as the asset can be repossessed should they fall behind on payments or default. The collateral reduces the risk for the lender, who can seize and liquidate the collateral to repay the debt in case of default.
Key Learning Points
- Secured borrowings are loans backed by collateral to mitigate the lender’s risk.
- In a case of default, the lender can seize and liquidate the collateral to cover the outstanding.
- The interest rates on secured borrowings are lower than those on unsecured loans.
- Secured borrowings are considered less risky because they are backed by collateral.
- Secured loan holders have priority over unsecured loan holders.
Understanding Secured Borrowings
Loans are classified as secured or unsecured. Secured debt is always backed by collateral, on which the lender holds a lien. The collateral asset provides security for the lender, and collateral is often required when the borrower is considered to be a poor credit risk. The collateral mitigates the risk of lending to such borrowers. Some types of assets accepted as collateral include cash held with a financial institution, insurance policies, and securities as well as fixed assets such as real estate and equipment.
The interest rates paid on secured loans are lower than interest rates on unsecured debt. In some instances, the borrower will volunteer collateral when it’s not required in order to benefit from a lower interest rate.
Secured borrowings have priority over unsecured debt in the case of bankruptcy. The borrower’s assets are sold and the proceeds are used to repay creditors. Lenders holding secured debt always have priority over unsecured debt holders. Holders of unsecured debt are repaid only after all secured debt holders have been fully repaid.
Examples of Secured Borrowings
Two popular forms of secured debt are auto loans and mortgages. The inherent structure of these loans automatically creates collateral. If the borrower defaults on a mortgage, the lender can repossess the property. In the case of an auto loan, the car can be repossessed.
Assume an individual takes out a $170,000 mortgage for a $200 000 property after making a 15% down payment. The property serves as the security in case of default. Say after two years there is $113,000 outstanding on the mortgage and the borrower defaults. The financial institution will liquidate the property at the current market value and use the proceeds to pay off the mortgage. debt. If the market value is less than the outstanding mortgage value of $113 000, the financial institution will cover what portion of the mortgage it can and then determine if it’s worthwhile to pursue the borrower. If the market price exceeds the outstanding mortgage balance, the surplus is distributed to the owner after all mortgage debt is satisfied.
Advantages and Disadvantages of Secured Debt
Borrowers with less than stellar credit ratings can access capital through secured borrowing, provided they have sufficient assets to pledge as collateral. While borrowers with better credit ratings benefit from lower interest rates, collateralized loans can give borrowers who might otherwise be excluded access to financing,
Secured loans, with the risk reduced by the collateral, can be offered for longer terms. Repayment periods on secured debt can extend to ten years or more.
One of the principal advantages of secured borrowing is the lower interest rate. Rates can start as low as 3.2%.
Secured borrowing also offers borrowers access to larger loans, provided they have sufficient collateral. Consequently, even borrowers with lower credit ratings can potentially fund significant investments.
Some types of secured debt allow for tax deductions as well. For example, mortgage interest payments of up to $750,000 are tax-deductible. For instance, borrowers can claim tax back on interest paid on mortgages up to $750,000.
On the other hand, secured borrowing has its negative aspects as well, the most obvious being the potential loss of collateral. This is particularly disadvantageous if the assets have appreciated in value since the loan was taken out.
Secured debt may carry a variable interest rate, while unsecured loans carry fixed interest rates. Should the base rate rise, the borrower may end up paying more for debt service than they anticipated.
The terms on secured debt can also be affected by the borrower’s income. Even though the importance of the borrower’s credit rating is reduced, banks will still favor borrowers with consistent income and a history of repaying loans.
Secured borrowing allows borrowers to take out loans backed by collateral. This is particularly attractive to borrowers with lower credit ratings, as it expands their opportunity to access affordable financing. Since collateral can be seized and sold to cover the debt in the event of default, the risk to the lender is reduced. However, there is still the risk that the collateral assets could decline in value, leading to the lender realizing lower proceeds in the event of default and liquidation.
Secured Borrowings – MCQ
Below is a multiple-choice question to test your knowledge. Download the Excel exercise sheet attached to find a full explanation of the correct answer.