What is a secured loan? How does it work?

A secured loan is a type of personal loan that requires a security (collateral) from the borrower’s side.

In easy words, a loan becomes secured when the lender has the right to take over any of the borrower’s assets as a means of future security in case of any default.

In secured loans, borrowers may see a lower interest rate and flexibility of bad credit score only because the lender has its future backup plan with your collateral.

The concept simply tells the theory of low risk, low return – where the bank (lender) does not need to worry much about the uncertainty of future payback volatility.

As an example, think about a house loan. The borrower takes the loan only to buy his/her house and the property becomes collateral of that particular loan.

You may also offer other assets as collateral to secure any personal loan, which mainly depends on the negotiation with your lender.

Key Takeaways

• A secured loan needs a security (collateral)
• It’s cheaper than the unsecured loan
• Secured loan payments affect the credit score
• Lenders may take additional time while assessing the value
• In case of default, the lender will take possession of your security
• You may restructure or reschedule your secured loan
• Taking multiple loans using the same collateral is tricky

Pros & cons of secured loan

Pros	Cons
Easier to avail	Risk of losing your asset in the future
Interest rate is lower than the secured loan	Its time consuming since the lender needs to assess the value of your collateral
Monthly installments hit your credit score help in secure low-cost loans in the future	In case of missed payment, your credit score would get affected
Higher borrowing limit
Longer repayment terms
Flexibility of use (like home equity loans or HELOCs, can be used for a wide variety of purposes)

Learn how to calculate APR for your secured loan and compare with offers from other lenders.

How many types of secured loans are there?

A secured loan is a concept of securing the loan from another asset. This is impossible to tell exact number of secured loans; however, here are a few examples:

• Mortgage Loans: Loans secured by real estate property. These are typically used for purchasing a property.
• Auto Loans: Loans secured by the vehicle being purchased. If the borrower defaults, the lender can seize the car and encash the due installments.
• Home Equity Loans: Loans secured by the equity in the borrower’s home. These can be used for various purposes, including home improvements/customization, debt consolidation, or other expenses.
• Home Equity Lines of Credit (HELOCs): Similar to home equity loans, these provide a revolving line of credit based on the equity in the home, which means the borrower will have access to a particular limit of credit that is secured by the borrower’s home.
• Secured Personal Loans: Loans that can be secured by various types of collateral, such as a savings account, certificate of deposit (CD), or other personal assets. One example can be secured overdraft (SOD). A secured overdraft is when the borrower takes a short-term loan and makes his savings (usually a fixed deposit) as collateral.
• Boat Loans: Loans specifically for purchasing boats, secured by the boat itself.
• Recreational Vehicle (RV) Loans: Loans for purchasing RVs, secured by the RV.
• Secured Credit Cards: Credit cards that require a cash deposit as collateral. The credit limit is usually equal to the deposit amount. Usually, people with no income proof apply for a secured credit card. For example, any unemployed person may apply for such a secured loan.
• Life insurance loan: Loans you make when you make your life insurance policy as collateral of that particular loan.
• Gold loan: This is another type of secured loan. In gold loans, borrowers usually keep gold as a security and take an equivalent or slightly higher amount of money. There is an interest that applies after a particular duration of the loan.

Is a bad credit loan secured?

A bad credit loan is a type of borrowing where the borrower’s credit score is not satisfactory to allow a loan.

A bad credit loan can be both secured or unsecured which purely depends on the lenders’ policy. If the amount is small, the lender may accept your bad credit loan application with a significantly larger interest rate.

However, bad credit loans can also be secured. Let’s say, you need to borrow 10 thousand USD and your credit score falls below 300.

What would you do?

You may present your car, or expensive assets as collateral of the loan. Remember, that’s all between you and the lender.

Who provides a secured loan? What would you need?

Usually, banks, credit unions, and online lenders provide secured loans.

To get a secured loan, you need a few preparations that can make the process faster. For example:

• Identify the amount you need and prepare a fund utilization plan
• Identify what can you utilize as collateral and revalue the item
• Analyze if the interest rate is fixed or variable (never go for the variable interest rate unless you are confident about the future economic outlook)
• Identify if your lender requires any processing fees
• Research what credit score would you need for that particular loan. If you have enough time, try building your credit score gradually.

Your preparation would vary depending on the type of the loan.

For example, Taking a secured credit card is easy if you have sufficient deposits in your bank account.

However, decisions may puzzle you when you are not sure yet about the collateral.

What happens if your secured loan becomes a default?

If you delay any installment of your secured loan, there will be two impacts. FIrst, your credit score would get hurt due to missed or late payment and secondly, you may encounter penal interest (penalty that is charged by the lender).

Usually, penal interest is only charged when someone makes multiple EMIs overdue.

We have listed some consequences in case someone defaults in a secured loan:

• A late fee or a penal interest would be applicable if the lender do not pay within 15 days starting from the date when his payment becomes due.
• Being defaulted on a secured loan would negatively affect your credit rating/score.
• If you become ineligible to make any payments for your loan, the lender will take your collateral under the lender’s possession and encash the money with regulatory power.

Here’s a hypothetical example:

A borrower has a mortgage payment of $1,000 due on the 1st of each month. The loan agreement includes a 10-day grace period and a 5% late fee. If the borrower pays on the 12th, they will incur a late fee of $50 (5% of $1,000).

Remember, the grace period is not the same for all institutions. That will be clearly written on your sanction letter.

Let’s imagine that your loan payment date (EMI due date) is January 1.

Your grace period is 10 days.

So, for the missed payment, your consequences would be as follows:

• January 11: Payment is late; lender charges a late fee.
• February 1: 30 days late; negative impact on credit score.
• March 1: 60 days late; further negative impact and lender warnings.
• April 1: 90 days late; significant credit score drop and aggressive collection.
• May 1: 120 days late; loan considered in default, foreclosure proceedings may start.
• June 1: 180 days late; loan is charged off, severe credit impact, and possible legal action.

What would you do in case of any missed payment?

In case you miss one or multiple payments of your secured loan, first you need to communicate with your lender and explore what options they have for you.

The first task is to communicate with your lender.

An effective official communication from the lender’s side may receive an extension of the grace period or removal of late fees. The lender may allow deferred payment flexibility, which depends on your earlier payment behavior.

You may ask the lender to reschedule or restructure your loan.

What does a rescheduling mean?

Rescheduling represents that you ask for a formal permission of the loan payments at a later date.

But, loan restructuring represents something else.

Let’s assume that you have made 19 payments out of your 60 EMIs. Now, you are facing difficulties paying with your EMIs.

You may request your lender to restructure loan, by making the due amount a new loan for an extended tenure. Restructuring loans may increase your costs but will effectively reduce the size of the monthly payment amount.

Example of loan restructuring

Scenario:

• Original Loan: Home loan of $300,000 with a 5% annual interest rate, 60-month (5-year) tenure.
• Monthly EMI: Approximately $5,660.
• Payments Made: 19 out of 60 EMIs.

Current Situation:

• Remaining Balance: Let’s assume the remaining balance after 19 payments is $230,000.
• Borrower’s Issue: Facing financial difficulties and unable to continue paying $5,660 per month.

Restructuring Request:

• The borrower requests the lender to restructure the loan by extending the tenure to reduce monthly payments.

Restructured Loan Terms:

• New Tenure: 120 months (10 years).
• Interest Rate: The same at 5% annually (assumption).

Calculation:

• New Monthly EMI: The restructured loan amount of $230,000 over 120 months at a 5% annual interest rate results in a new EMI of approximately $2,436.

Result:

• Old EMI: $5,660
• New EMI: $2,436
• Impact: Monthly payments are significantly reduced, making it easier for the borrower to manage their finances. However, the borrower will end up paying more interest over the extended tenure.

Example of loan rescheduling

Scenario:

• Original Loan: Auto loan of $30,000 with a 6% annual interest rate, 36-month (3-year) tenure.
• Monthly EMI: Approximately $912.
• Payments Made: 12 out of 36 EMIs.

Current Situation:

• Remaining Balance: Let’s assume the remaining balance after 12 payments is $20,000.
• Borrower’s Issue: Temporary cash flow problem, unable to pay the EMI for the next 3 months.

Rescheduling Request:

• The borrower requests the lender to reschedule the loan by deferring the next 3 EMIs and extending the loan term accordingly.

Rescheduled Loan Terms:

• New Tenure: Original tenure extended by 3 months (now 39 months total).
• Interest Rate: The same at 6% annually.

Calculation:

• Deferred EMIs: The EMIs for the next 3 months (total $2,736) are added to the remaining loan balance.
• New Loan Balance: $20,000 + $2,736 = $22,736.
• New Monthly EMI: The new loan balance of $22,736 over the remaining 27 months (3 deferred + 24 remaining) at a 6% annual interest rate results in a new EMI of approximately $875.

Result:

• Old EMI: $912
• New EMI: $875
• Impact: The borrower gets temporary relief by deferring the EMIs for 3 months, and the overall loan tenure is extended. The monthly payments are slightly reduced due to the extended term, but the borrower will pay more interest overall due to the rescheduling.

Can you use the same collateral for multiple secured loans?

Typically, using the same asset as collateral for multiple loans is not accepted.

There are legal and financial complexities too.

When you use an asset as collateral for a loan, the lender typically places a lien on that asset. This lien gives the lender the right to take possession of the asset if you default on the loan. The lender with the first lien has the primary claim to the asset. (This is called the first lien).

However, in some cases, a second lien is possible.

The second lien represents taking out a second loan using the same asset.

But, the second lender’s claim on the asset is subordinate to the first lender’s claim. This means that if you default, the first lender gets paid off first, and the second lender gets paid with whatever is left if anything.

The bottom line

A secured loan is easy to avail if you have sufficient encashable assets as collateral. In a secured loan, the effective interest is lesser than the unsecured loan, and loan terms would be flexible if you have income proof and credit history.