Secured Debt: What is, Defition with Example

What is a Secured Debt?

Secured debt is debt that is backed or secured by collateral in order to reduce the risk of lending. If a borrower fails to repay a loan, the bank seizes the collateral, sells it, and uses the proceeds to settle the debt. As a result of the fact that assets backing debt or a debt instrument are considered a form of security, unsecured debt is regarded as a riskier investment than secured debt.

• Secured debt is debt that is backed by collateral in order to mitigate the inherent risk of lending.

• If a borrower defaults on a loan, the bank may seize the collateral, sell it, and use the proceeds to repay the debt.

• Because secured loans are backed by collateral, they are deemed to be less risky than unsecured loans or those without collateral backing.

• Secured debt carries a lower interest rate than unsecured debt.

In the event of bankruptcy, secured creditors are always repaid before unsecured creditors.

Understanding About the Secured Debt

Secured debt is debt that is always supported by collateral on which the lender holds a lien. It gives the lender additional security when lending money. Secured debt is frequently associated with borrowers with poor credit. Due to the high risk associated with lending to a person or business with a low credit score, securing the loan with collateral significantly reduces this risk.

For example, assume that Bank ABC lends money to two individuals with poor credit. Unlike the second loan, the first loan is secured by collateral. After three months, both borrowers are unable to make their loan payments and default. With the first secured loan, the bank has the legal right to seize the collateral. After that, they typically sell it at auction and use the proceeds to repay the remainder of the loan.

In the second loan, which is unsecured, the bank has no collateral to seize in order to recover the outstanding balance. In this case, the loan must be written off as a loss on the company's financial statements.

When a loan is secured, the interest rate offered to the borrower is frequently significantly lower than if the loan were unsecured. When a loan does not necessarily require collateral, such as a personal loan, it may be in the borrower's best interest to provide collateral in order to obtain a lower interest rate. They should only do so if they are confident in their ability to continue repaying the loan or if they are willing to forfeit the collateral if they cannot.

Priority of Secured Debt

If a business declares bankruptcy, its assets are put up for auction to repay its creditors. In the repayment scheme, secured creditors always take precedence over unsecured creditors. After all secured creditors have been repaid in full, only then are unsecured creditors compensated.

If the proceeds from the sale of the assets are insufficient to repay unsecured creditors, those creditors will incur a loss. If the proceeds are insufficient to repay the secured lenders, depending on the circumstances, the secured lenders may pursue other assets of the company or individual.

Secured Debt - Example

Mortgages and auto loans are the two most typical examples of secured debt. This is the case because their inherent structure generates security. When a borrower defaults on their mortgage payments, the bank has the right to seize their home. Similarly, if a person defaults on an auto loan, the lender can seize the vehicle. In both instances, the collateral (the home or the vehicle) will be sold to satisfy the debt.

For instance, John obtains a $15,000 auto loan from a bank. The loan is secured because John's automobile serves as collateral that the bank can seize if he defaults on his payments. After two years, John's loan balance is still $9,000, and he suddenly loses his job. The bank seizes his car because he can no longer make his loan payments.

If the car's current market value is at least $9,000, the bank will be able to cover the remaining balance after selling it and collecting the proceeds. If the car's market value is less than $9,000, for example $6,000, the bank will cover $6,000 of the outstanding debt, leaving $3,000 unpaid. Depending on the circumstances, the bank may pursue John for the remaining $3,000 owed.