Definition of secured loan
What is a secured loan?
A secured loan is a loan that a third party guarantees (or assumes the debt) in the event that the borrower default values. Sometimes a secured loan is guaranteed by a government agency, which will buy the debt from the lending financial institution and take responsibility for the loan.
Key points to remember
- A secured loan is a type of loan in which a third party agrees to pay if the borrower defaults.
- A secured loan is used by borrowers with poor credit or few financial resources; it allows financially unattractive applicants to qualify for a loan and ensures that the lender will not lose money.
- Secured mortgages, federal student loans, and payday loans are all examples of secured loans.
- Secured mortgages are generally guaranteed by the Federal Housing Administration or the Department of Veterans Affairs; federal student loans are supported by the US Department of Education; payday loans are secured by the borrower’s paycheck.
How a secured loan works
A secured loan agreement can be entered into when a borrower is an unattractive candidate for a regular bank loan. It is a way for people who are in need of financial assistance to obtain funds when they would not otherwise be able to qualify to acquire them. And the guarantee means that the lending institution does not incur excessive risk in issuing these loans.
Types of secured loans
There are a variety of secured loans. Some are safe and reliable ways to raise money, but others come with risks that can include unusually high interest rates. Borrowers should carefully consider the terms of any secured loan they are considering.
An example of a secured loan is a secured mortgage. The third party guaranteeing these home loans in most cases is the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA).
Homebuyers who are considered subprime borrowers – they are not eligible for a conventional mortgage, for example, or if they don’t have an adequate down payment and have to borrow almost 100% of the value of the house — they can get a secured mortgage. FHA loans require borrowers to pay mortgage insurance to protect the lender in the event the borrower defaults on their home loan.
Federal student loans
Another type of secured loan is a federal student loan, which is guaranteed by an agency of the federal government. Federal student loans are the easiest student loans to get – there’s no credit check, for example – and they have the best terms and lowest interest rates because the US Department of ‘Education secures them with taxpayer dollars.
In order to apply for a Federal Student Loan, you must complete and submit the Free Federal Student Aid Application, or FAFSA, each year that you wish to remain eligible for Federal Student Aid. The repayment of these loans begins after the student leaves college or falls below half-time enrollment. Many loans also have a grace period.
The third type of secured loan is a payday loan. When a person takes out a personal loan, their paycheck plays the role of the third party who guarantees the loan. A lender gives a loan to the borrower, and the borrower writes the lender a post-dated check that the lender then cashed on that date, usually two weeks later. Sometimes lenders will need electronic access to a borrower’s account to withdraw funds, but it is best not to take out a secured loan under these circumstances, especially if the lender is not a traditional bank.
Secured payday loans often trap borrowers in a cycle of debt with interest rates of up to 400% or more.
The problem with payday loans is that they tend to create a cycle of debt, which can cause additional problems for people who are already in dire financial straits. This can happen when a borrower does not have the funds to repay their loan at the end of the typical two week term. In such a scenario, the loan turns into another loan with a whole new set of fees. Interest rates can be as high as 400% or more, and lenders typically charge the highest rates allowed by local laws. Some unscrupulous lenders may even attempt to cash a borrower’s check before the posting date, creating an overdraft risk.
Alternatives to secured payday loans understand unsecured personal loans, which are available from local banks or online, credit card cash advances (you can save a lot of money compared to payday loans even with rates on advances up to 30%) or a loan from a family member.