When banks lend money, they break the loans down into two very broad categories. The first is secured loans, and the second is unsecured loans. For the most part, banks prefer to make secured loans because if they have to foreclose on the note, they have some type of tangible property to seize and sell to recover all or most of their money. However, banks make unsecured loans because the profit potential is higher if the loans are repaid. Understanding what an unsecured loan is will help you to see why this type of loan carries more risk to the bank and a higher interest rate to the borrower.
Secured debt is always backed by some type of property.
This security property may be a house, car, home appliance, or money. In cases where a person has a long term certificate of deposit, it can be better to make a short term secured debt with the certificate of deposit backing it than to break into the savings account and take penalties for not leaving all of the money in the bank.
The bank will always hold the title to whatever is backing a loan until the loan is repaid in full.
Contracts are drawn up when the loan is initiated that state that the bank has the right to claim the property and sell it if the owner fails to pay the debt off. If it is a certificate of deposit, the bank can simply withdraw the amount of money that is owed from the account when the borrower defaults.
Unpaid secured loans cause the forfeiture of the property.
When secured loans are not repaid, people can be evicted from their foreclosed house. Other will have their car repossessed. No one is happy when a secured debt is not paid. Banks do not like taking cars and houses. They are in the money business not real estate and auto sales. People often blame the bank when they lose their home or car, but it is not the bank’s fault that the loan was not repaid according to the contract.
Unsecured debt is based on the borrower’s perceived ability to repay the debt.
Credit card companies are large holders of unsecured debt. With credit cards, the person’s credit history is reviewed. If the person has a decent history of paying off debts, a credit card is issued with a borrowing limit. Other unsecured debt can be like a payday loan. The borrower shows a stub from a paycheck to prove that he or she is employed. A relatively small amount of money is loaned. Normally, these loans range from $50 to $250.
On unsecured debt, the interest rate will be higher than secured debt.
With credit cards, the interest rate will vary between six percent and 35 percent per year. The interest rate is set to match the amount of risk the bank assesses to the borrower based on the credit history. With payday loans the interest rate can reach up near 1,000 percent per year. These lenders are not regulated as tightly as banks and have a very high risk of default. So, their interest rates reach to the sky.