There are numerous ways to borrow money. When you take out a loan you will be charged a specific interest rate for it. But one of the questions that I have been asked is why do unsecured loans have a higher interest rate than secured loans? Let me explain.
What is an Unsecured Loan?
There are two types of loans.
- Secured loans
- Unsecured loans
A secured loan is any loan that has collateral that can be repossessed in the event that the borrower defaults on the loan.
In other words, the bank has the security of an item.
An unsecured loan does not have an item that can be repossessed in the event of default from the borrower.
Some examples of secured loans are loans given to pay for:
- Real estate
- Vehicles
- Boats
- Campers
- Pretty much anything with a title
Some examples of unsecured loans are:
- Credit cards
- General unsecured loans from a bank
- Student loans
- Family loans (usually)
Why do Unsecured Loans Have Higher Interest Rates?
As a general rule, unsecured loans have higher interest rates than secured loans.
This is because there is a higher chance of default by the borrower with unsecured loans.
Think about it like this. Is a borrower more likely to default on a credit card or on a vehicle?
The answer is a credit card.
And the bigger reason that unsecured loans have higher interest than secured loans is really because what is the bank to do when someone defaults on a loan?
If someone defaults on a mortgage, the bank forecloses and takes the house.
If someone defaults on a car payment then the bank repossesses the car and then sells it at auction.
And if someone defaults on their boat payment then the bank can repossess that as well.
But what if someone defaults on a loan that has no collateral? The bank can sue them to get repaid, but there is no other recourse. They cannot try to get the collateral back because there is no collateral.
If you were to default on a credit card, the bank cannot take the food out of your pantry, the gas that you put in your car, or the movie tickets that you purchased with the credit card. They can only sue you for what you defaulted on.
And because of this, it is more risky to the bank to loan out unsecured loans. And because there is a balance of risk and reward (for investors as well as banks), they demand a higher interest rate (reward) for an unsecured loan.
Final Thoughts
Whenever you take out a loan, be careful. Sometimes taking out a loan can be a good thing. Especially if it makes you money in the long run. But be careful doing so. Especially if you have to pay off a higher interest rate because it is an unsecured loan.
You can do this!
I am here for you!
Until next time!
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