What is secured debt?
Secured debt is backed by debt or secured by collateral to reduce the risk associated with the loan. If the borrower on a loan defaults, the bank seizes the collateral, sells it, and uses the proceeds to pay off the debt. Assets backed by a debt or debt instrument are considered a form of collateral, which is why unsecured debt is considered a riskier investment than secured debt.
Key points to remember
- Secured debt is debt backed by collateral to reduce the risk associated with the loan.
- If a borrower does not repay their loan, a bank can seize the collateral, sell it, and use the proceeds to pay off the debt.
- Since secured loans come with collateral, they are considered to be less risky than unsecured or unsecured loans.
- The interest rate on secured debt is lower than that on unsecured debt.
- In the event of a business bankruptcy, secured lenders are always repaid before unsecured lenders.
Understanding secured debt
Secured debt is debt that will always be backed by collateral, over which the lender has a lien. It provides the lender with additional security when lending money. Secured debt is often associated with borrowers with low creditworthiness. Since the risk of lending to an individual or business with a low credit rating is high, securing the loan with collateral significantly reduces this risk.
For example, suppose ABC Bank grants a loan to two people with poor credit scores. The first loan is backed by collateral while the second is not. After three months, the two borrowers can no longer repay their loans and default. With the first loan, backed by a guarantee, the bank is legally authorized to seize this guarantee. After that, they sell it, usually at auction, and use the proceeds to pay off the unpaid portion of the loan.
In the second loan, where there is no collateral, the bank has no collateral to seize to repay the outstanding debt. In this case, they will have to write off the loan as a loss on their financial statements.
When a loan is secured, the interest rate offered to the borrower is often much lower than if the loan was unsecured. Sometimes when a loan does not necessarily require collateral, such as a personal loan, it may be in a borrower’s best interest to put up some form of collateral to qualify for a lower interest rate. They should only do this if they are sure they can continue to repay the loan or are prepared to lose the collateral if they cannot.
Priority of secured debt
If a company files for bankruptcy, its assets are put up for sale to pay off its creditors. In the payback scheme, secured lenders always have priority over unsecured lenders. Assets are sold until all secured lenders are fully repaid, only then unsecured lenders are repaid.
If the assets are sold and there is not enough proceeds to pay off the unsecured lenders, they are lost. If there is not enough proceeds to pay back the secured lenders, depending on the situation, the secured lenders may go after other assets of the business or the individual.
Examples of secured debt
The two most common examples of secured debt are mortgages and auto loans. This is so because their inherent structure creates guarantees. If an individual defaults on their mortgage payments, the bank can foreclose on their home. Likewise, if an individual defaults on their car loan, the lender can seize their car. In either case, the collateral (the house or the car) will be sold to collect the outstanding debt.
For example, Mike takes out a $ 15,000 car loan from a bank. The loan is secured debt because the car serves as collateral that the bank can grab if Mike doesn’t pay off his loan. After two years, there is still $ 10,000 to pay on the loan and Mike suddenly loses his job. He can no longer repay the loan, so the bank seizes his car.
If the current market value of the car is $ 10,000 or more, when the bank sells it and collects the proceeds, it will be able to cover the remaining debt. If the market value of the car is less than $ 10,000, say $ 8,000, the bank will cover $ 8,000 of the unpaid debt, but it will still have $ 2,000 of the debt left. Depending on the situation, the bank may go after Mike for that remaining $ 2,000 debt.