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With a secured loan, the lender takes a charge on a personal asset such as your home. If you default on repayments of capital and interest, the lender can take possession of the asset and sell it to recoup outstanding capital and interest and to recover its costs.
In theory, a charge may be taken on any kind of asset, but it is usual for it to be taken against a residential property. There are two varieties:
- Where the lender takes the primary charge on the property.
- The so-called 'homeowner loan' in which the lender takes a second charge on the borrower's home behind the primary mortgagee.
Secured loans can be used to finance expenditure on consumer goods and services (such as cars and holidays) as well as home purchase.
These are often taken out by borrowers who have difficulty in raising unsecured loans because of an “impaired” debt history (arrears, CCJs etc.).
The loan limit is usually based on the surplus equity in the property (i.e. the property value minus the primary mortgage) but some lenders will advance loans of 125% of spare equity at a higher interest rate.
The advantage to the borrower is that capital repayments can be spread out over an extended period thereby easing the pressure on cash outflow.
The main disadvantages are:
- The rate of interest rate is higher than on conventional mortgages and possibly on unsecured loans, because of the quality of the lending and the fact that the lender only has a second charge on the property.
- The total interest paid over the term of the loan can be much higher than on a shorter-term unsecured loan. The debt may persist well beyond the life of the goods financed.
- There may be penalties for early redemption.
- There are likely to be upfront costs like valuation and arrangement fees, although this can also be true of mortgage top-ups to finance consumption expenditure.
- The reduction in monthly cash-outflow may be an incentive to take on further debt.
Many people have a variety of simultaneous credit card debts and unsecured loans. These can be “consolidated” in a single secured loan, repayable over an extended period. The interest rate is often lower than the rate charged on credit card balances, but this depends on the individual borrower.
Consolidated loans are more transparent than a “portfolio” of disparate loans from several lenders, and only one rate of interest is charged. However, they have all the pitfalls of homeowner loans and are seldom the answer to spiralling personal debt.