Understanding rationale for security in borrowing

ASECURED loan is a loan that has collateral attached to it. This type of loan generally has a lower interest rate because the bank is taking a lower risk because it can collect the collateral if you default on payments. A secured loan is a good way to build credit. The debt is thus secured against the collateral. In the event that the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or the entire amount originally loaned to the borrower, for example, foreclosure of a home.

From the creditor’s perspective this is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property.

If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount.

Some loans define collateral as the asset you’re borrowing to acquire. For example, when you buy a home, the home you purchase is often the only collateral available.

Other loans allow you to choose from or propose a broader range of assets. For example, small business loans may require collateral, and you can negotiate which assets are best for you to recover your money in case of default.

There are several types of secured loans. Mortgages, equipment purchase and car loans are the most common types of loans.

You can also get a secured credit card by attaching a Certificate of Deposit (CD) to a credit card. Banks will do this for customers who are trying to rebuild their credit history. The credit limit will be about the same amount as the CD and if you fail to pay, then the bank takes money from the attached CD.

Collateral is something of value - an asset or property - that you pledge when getting a loan. If you don’t repay the loan as agreed, the lender can take your collateral and sell it. You can use a variety of assets as collateral.

Physical assets like houses and cars may be used, and intangible assets like bank accounts and investment holdings might qualify depending on your loan.

Unsecured loans are not attached to any collateral and these are loans that are primarily small amount loans used to cover home improvements, small purchases or to cover unexpected expenses.

They’re “unsecured” loans because the bank has nothing to go after if you default. They can’t sell your house like they could with a mortgage, for example. Because they’re just taking your word for it, you have to have decent credit to get an unsecured loan.

Unsecured loans are sometimes called “signature loans” because the bank has nothing but your signature. In other words they can’t take possession of your house, car, or other belongings. However, they can report you to the credit reporting companies and affect your credit history.

Why Collateral?

If you risk losing something, why pledge it as collateral? It may be because there’s no other way to get a loan. Banks won’t lend you enough money to buy a house unless they can take the house back and sell it when things go bad (this is known as foreclosure).

By extending the loan through securing the debt, the creditor is relieved of most of the financial risks involved because it allows the creditor to take the property in the event that the debt is not properly repaid.

Debtors receive loans on more favourable terms than that available for unsecured debt, or to be extended credit under circumstances when credit under terms of unsecured debt would not be extended at all. The creditor may offer a loan with attractive interest rates and repayment periods for the secured debt.

Collateral is important because lenders want you to have some input in the game. They’re taking a risk so they want you to risk something too.

Large loans and borrowers without a solid credit history are most likely to need collateral. Lenders define collateral requirements; if you can’t meet them you may have to pay higher rates or find another lender.

Secured loans are an excellent way to work towards building your credit score. Banks like them because there is less risk involved. The lower interest rates are also an advantage to choosing a secured loan.

You should be careful as you choose what you will use as collateral most banks require a home or a car in order to give the loan, although a savings account may work, but you will not be able to access that money for the entire duration of the loan.

One potential problem with collateral is that if a borrower is unable to pay off a loan as scheduled, the assets used as collateral will be seized and sold, and the money raised by selling the assets will be used to offset the loan balance.

However, the market value of the collateral depends on factors outside the control of both the lender and the borrower. In such instances, if it so happens that the collateral value does not liquidate the loan balance, it leaves the borrower exposed and still liable to the lender for the difference.

Sanderson Abel is an Economist. He writes in his capacity as Senior Economist for the Bankers Association of Zimbabwe. For your valuable feedback and comments related to this article, he can be contacted on abel@baz.org.zw or on numbers 04-744686 and 0772463008

One potential problem with collateral is that if a borrower is unable to pay off a loan as scheduled, the assets used as collateral will be seized and sold, and the money raised by selling the assets will be used to offset the loan balance