Secured Loans

Secured Loans

A secured personal loan is a loan that has a specific asset (or multiple assets) as collateral. A mortgage is perhaps the most common type of secured loan with which most consumers are familiar. However, secured loans can also include automobile loans, secured credit cards, or secured lines of credit, amongst others. In essence, if a specific asset backs a loan you hold to the point where defaulting on the loan would transfer the ownership of the asset to the lender, then that is a secured loan.

Secured loans are primarily offered by banks, credit unions, and online lenders. When considering the different options of secured loans, it is important to consider a few variables before pulling the trigger. First, consider the type of collateral required for the loan. For example, a mortgage will always have a requirement to secure the property for which it is lending the funds. A similar story arises with a car loan wherein it will be secured by the automobile. That is unavoidable. However, for a secured loan such as a second mortgage, ensure that you still have adequate income and cash flows to periodically service this new loan. Failure to do so could lead to serious consequences, including the loss of your home.

Another variable to consider is the interest rate, and Annual Percentage Rate (APR) charged on the loan. Quite simply, the interest rate is the cost of borrowing money and can range widely depending on the borrower’s creditworthiness and the quality of the collateral asset. On the other hand, the APR is a broader calculation that encompasses all the additional mandatory costs of obtaining the loan, such as administrative fees, closing costs, etc. The APR is then expressed as a single number on an annualized basis that allows the borrower to assess exactly how much they would pay on top of regular principal payments each year. However, just knowing the interest rate is not the end of the story. As a borrower, it is your responsibility and in your best interest to know whether the rate is fixed or variable. A variable rate means that as the underlying reference rate off which the rate is based increases, the rate will increase. The reverse is true when the reference rate falls. As such, you may end up paying up to double or more in interest each month over the life of a mortgage if you are not vigilant about what type of rate you have obtained.

The last major item to consider is the term of the loan. This loan term impacts how much you make in monthly repayments. A longer-term means that each monthly amount will be lower. However, that also means you will pay more in interest over the life of the loan. Before selecting your loan term, make sure you understand your monthly cash flow and how much room you have for debt service (i.e., principal and interest payments). If you determine that you have enough capacity after fulfilling all your other expense obligations, then a shorter term may be the better option to prevent higher interest costs. Beyond the rate/APR, term and collateral, other factors to consider may include the amount of the principal you are undertaking, as well as additional fees or penalties that you will be required to pay for non-compliance with loan terms (such as late fees). In particular, the principal amount should be one that you are comfortable paying over the life of the term. When it comes to secured loans, it is imperative to not over-stretch yourself as there is now a clear asset at stake that you can lose in the event of default.

As mentioned above, there are many types of secured loans available to consumers. For the purposes of this section, we will focus primarily on one of the most common and essential loans taken out by borrowers in their lifetime: the mortgage. Statistics compiled by Statistics Canada at Q3 2020 showed that outstanding mortgages in major Canadian cities across the provinces of Ontario, British Columbia, Quebec, Alberta, Saskatchewan, Manitoba, and Nova Scotia totalled approximately $964 billion.

Canadian Mortgages in Major Cities by Province

Before signing a mortgage on the dotted line, several best practices should be kept in mind and followed. While these are generally useful for mortgages, borrowers can also apply them to other secured loans to ensure they obtain a loan in line with their preferences and constraints. The first best practice is to apply for a mortgage pre-approval. This pre-approval provides set parameters for how much you can spend, ensuring that you don’t attach yourself too deeply to a home that you cannot afford! You can then compare this pre-approval with other lenders or use a mortgage broker to negotiate on your behalf. Remember that even half a percentage point can save thousands of dollars over the course of the loan’s life when it comes to mortgages.

To facilitate the mortgage approval process, borrowers are advised to gather their documentation as soon as they feel ready to approach a lender with their mortgage request. For secured loans, this documentation includes the following as a baseline: (i) identification verification (generally, lenders require 2 pieces of ID), (ii) bank account statements, (iii) proof of asset ownership (i.e., for a mortgage, this will be the property deed), (iv) proof of income (generally, pay stubs will suffice for people employed by an employer. However, if you are self-employed, you may need to provide historical notices of assessment), and (v) credit reports which include your credit score as well as information on other outstanding debts that you have, and your repayment patterns on them. Lenders may also request other information outside of the above, particularly if you have other debts concurrently. As a general rule, it is always best to be honest about these debts when asked for further information. Dishonesty is almost always discovered sooner or later and, in some cases, may even open you up to legal action from the lender.

Now that we have discussed how to obtain a secured loan and what to look out for, the final question is whether a secured loan is the best choice for you. The primary advantage of a secured loan is that it gives you access to credit at a lower interest rate than an unsecured loan since there is collateral backing the loan. This means that the risk of default to lenders is much lower. In the worst-case scenario, they can sell the asset pledged to recoup their capital. This also means that lenders are willing to provide larger principal amounts if the borrower requires longer terms. For example, mortgages have terms of 20 to 25 years. Lenders are comfortable with these longer terms, particularly for real estate and property assets, as these have historically proven to appreciate in value over time. A further upside provided by a secured loan is that it enables the borrower to build (or rebuild) their credit. Making scheduled payments gets reported favourably to credit agencies, providing a boost to your credit score.

At the same time, however, a secured loan may not be the best option for everybody. The biggest downside is the potential loss of the asset if and when the borrower fails to make scheduled repayments. In the worst-case scenario, a house can go into foreclosure even if the borrower has owned the property for a long time. As with any other credit transaction, failure to make timely repayments also negatively impacts your credit score.

With all of these considerations, it is important to ensure that you are doing all you can to protect yourself, your family, and your assets if you choose to obtain a secured loan. This means budgeting your money conservatively each month to determine the level of repayments you can afford. Start with your monthly cash inflows and then subtract all your fixed and variable expenses, including your monthly mortgage payment, phone bill, WiFi, hydro, food, entertainment, and/or debt repayments, for any other expenses you have. This can enable you to see exactly how much spare capacity you have to make loan repayments each month. As a good practice, you should ideally look to have at least 10% in savings even after accounting for the new mortgage, for miscellaneous, emergency payments that you may encounter from time to time. Given that you now have an asset at stake, it is in your best interest to secure a loan where you do not pay more than your spare capacity allows.

 

credit tips!

Once you have applied to be pre-approved for a secured loan, it’s not the end of the story. You should continue maintaining the same financial discipline. In particular, try not to make any major purchases, at least until the loan approval. You should also not apply for any new credit or switch jobs if possible. In general, it is best not to show any major changes to your financial position from the time you applied for the pre-approval to the time of loan finalization.

Read the fine print very carefully when obtaining a new unsecured loan. Know whether the loan you are undertaking has a fixed or variable interest rate, and understand clearly what penalties or fees you will have to pay if you do not comply with the terms of the loan. Only once you are satisfied with each section of the credit agreement should you sign the loan. Remember that the stakes are much higher with a secured loan than an unsecured loan.

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