When learning about loans, it’s important to understand the difference between loans that require some sort of collateral versus loans that are unsecured. A collateral loan is a loan where the bank can get something back in case you default. For example, if you get a car loan but don’t make your monthly car payments, the bank can reposses the car. In contrast, if you owe a lot of credit card and go bankrupt, the credit card company is pretty much out of luck.

 

Since a bank’s risk with a collateral loan is theoretically lower, since it at least gets the collateral in case of default, they are more willing to make these sorts of loans and can make them at lower interest rates. However, the recent subprime crisis illustrated what happens when banks take these policies too far. Many banks made subprime loans to people, in the belief that these people’s homes would go up in value. So even if these people were unable to make payments, they could refinance the house or just sell the house and still make a little profit. Of course, we all saw what happened when house values started going down.

 

When you take out a collateral loan, you generally make monthly payments. For example, when you buy a car and get a car loan, you pay off the car monthly, generally over 36-60 months. During this whole time, the car itself acts as the collateral for the loan.

 

With an unsecure loan, the bank only has your word that you will repay them. Yes, you have the legal obligation to do so, but if you end up going bankrupt, the bank will never be able to get repaid. This is why unsecured loans tend to be for much less and at a higher interest rate. You generally need a good reason to get an unsecure loan. For example, a short-term cash crunch or perhaps a business opportunity. It’s not wise to take out unsecured loans (by going into credit card debt) to just go on a spending spree.

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