Secured vs Unsecured Debt? Huh?

Secured vs. Unsecured....what does this mean.....

again from wikipedia:

A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. 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 satisfy the debt by regaining the amount originally lent 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. The opposite of secured debt/loan is unsecured debt, which is not connected to any specific piece of property and instead the creditor may satisfy the debt against the borrower rather than just the borrower's collateral.

So in human terms.....

To pledge some asset: this means that the loan is for something of value, for example a car or a house. That means that the loan will be based on the value of that something. That something is also used as "security" for the lender; or

Secured against the collateral: this means that the value of the loan is backed by the value of something, and that if the borrower doesn't pay (defaults) on the loan, the lender has the right to that "something", therefore recovering the money they lent with the value of that "something"

So here's an example:

You want to buy a car. The car you want costs $3500. You only have $200, so you have choices:

1. You can save up the additional $3300, or
2. You can borrow the $3300

So let's say you go to the dealership, and decide that you really want the car right now, and you work with the "finance guy" and the dealership offers you a loan for the $3300. That loan comes with certain obligations (and yes, I'll go through all of the definitions of the terms associated with a loan going forward on this series on debt).

The deal is that you will have to pay $330/month for the next 10 months (to keep it simple).

$330 X 10 = $3300

So you agree, shake hands, sign on the dotted line and you drive off in your new car.

Every month you will have to make payments if not, the dealership has the right to pick up your car and try to sell it. Until you pay the last penny owed to the dealership, they have a hand on the car.

So you are going along, and 5 months down the line, you lose your job, used your money for something else, or forgot to pay your $330 payment. The dealership has the right to come and get the car and try to sell it to recover the outstanding amount you owe them. So let's do the math.

After 5 months, you would have paid: $1650 ($330 X 5). This means that you still owe $1650 on the car loan.

The dealership can take the car and try to sell it to see if it recovers the $1650 that still hasn't been repaid.

So let's say they do come and pick it, and sell it; there are a few outcomes:

• They put it on the lot and are able to sell it for exactly $1650 - you think you are in the clear right? wrong! they could still come back to you and ask you to pay additional fees associated with the pick up and sale of the car (wrecker, parking fees, tax, etc)
• They put it on the lot and are able to sell it for $3000 - wow, now you really think you scored, you think they will give you the additional monies to $1650 they received ($1450). Though you may receive a little something, it isn't likely, because of the above mentioned fees and costs, but if
• They put it on the lot and sell it for only $1000, you are still on the hook for the additional $650. Though it will be tough for them to collect, (now this is the benefit of a secured loan), their security is the car, or it's value. They should not be able to satisfy the loan against the borrower but only against the asset. hmmmmmm????

So why would the dealership lend you money for a car? What makes it a deal for them? How can they estimate the value of the car down-the-road in case you don't make payments (default) on the loan? In my next post I'll walk you down the road of an actual loan for an asset. How the bank determines payments, interest rates, term of loan, etc. All of that is linked to your "creditworthiness" and the value of the asset.

"Creditworthiness" - for everyone the bar is set differently. We each set that mental bar using past experiences with that person, or past experiences with other people.

We all have friends who we would lend money to, and those who we wouldn't lend a book to much less money, right? Well, every time you make that distinction, you are basing it on the "creditworthiness" of your friend.

For example, if I let you borrow something in the past, and you returned it without me having to beg you to return it (and by something I mean anything: money, clothes, a book, etc). I also have probably observed what other friends have gone through when letting you borrow something. All of that forms an opinion on your trustworthiness or creditworthiness.

It doesn't mean that that friend is a bad person, it just means that if I want to keep them as a friend and not get upset and mad at them, I just avoid putting myself in the situation in the first place. I just don't lend them things, I prefer to "give" them things not "lend" them things.....

Banks and credit card companies look into your creditworthiness, however since they aren't your friends, they most likely will look at your credit report and your FICO score to determine your creditworthiness (I'll go through credit reports and FICO scores in a future post).

Back to loans......What does an unsecured debt mean?

An unsecured debt or loan is exactly what it sounds like.

It is a loan based only on the creditworthiness of the borrower. If the borrower doesn't pay (defaults) on the loan, the lender can "satisfy the debt against the borrower" (sue the borrower)....

Ok, let's humanize:

So an unsecured loan would be a credit card for example. When a bank or credit card company issues you a credit card. They determine your creditworthiness to see not only if they'll give you a credit card, but what your credit limit is and what your interest rate will be.

Why is a credit card unsecured? Well let's assume that you don't pay your credit card bill. Do you think the credit card company will come to your home and start looking for everything you bought on the credit card and try to take it and sell it? NO!!!! They could never do that, not only because imagine what a pain it would be for the credit card company or bank to come to your home and look through your home, but because most of the time the stuff we buy on credit cards no longer exists (food, a night out, tickets to the movies).

Since the debt is not secured, the only thing they can do (aside from harassing you on the phone - which they can't do if you tell them to stop by the way!) is sue you. Every state has different rules, but in some States, the credit card companies can sue you for the balance due on your card plus legal fees for suing you. If they win the lawsuit there States where the judge can issue a withholding order on wages, deposits into bank accounts, a lien on your house, etc.). So even though you think they can't do anything, they can and will.

By the way peeps.....

The loans from your mom and dad, yup, if you are calling them loans, they are unsecured and they could in fact sue you for it. Mom's and Dad's out there, if you are "lending" your children money, make sure that everyone knows it is a loan and not just "help" to never be repaid. Make sure you have an expected date of repayment and that everyone involved knows when that is, if you don't, and you expect to get paid, expect to be disappointed or upset.

Everyone's expectations are usually different and everyone's view of parental loans is different. Make sure everyone is on the same page.

There have been times in my life when I've needed money for different things. I would ask family members to lend me the money only when I had full intention on paying them back. If I didn't think I was going to pay it back, I would ask my family members for a gift of money or to "help me out" and would tell them straight out, that I didn't think I would be repaying them. However, if I borrowed the money, I always always always, paid it back (grant it my family never charged me interest and I never paid interest) but it was important to make sure that everyone was clear on what to expect.

I learned this from my Grandmother, one time when I asked to borrow money for a car payment, she looked at me and said, "I think I would rather give you the money. Right now you are in a hard sport and you will probably be better off not worrying about paying me back". When I looked at her a bit startled, and very grateful, she let me in on the difference between asking to "borrow" and asking for "help".

See you next post to talk about interest, principal, term of loans, and more debt related stuff....

Cheers!