Secured and Unsecured Lending
What’s the difference between secured and unsecured lending?
That’s a no-brainer, right? Secured lending has a safety net; you can seize assets from the borrower if they are unable to repay their debt, and sell them to get your money back. Unsecured lending has no safety net; success depends on the borrower continuing to have enough income throughout the life of the loan to meet all the repayments. If their income dries up, you will have to pursue them through the legal system to recover your cash. If the loan is small, the costs might be too high to make the effort worthwhile.
Why would anyone lend an unsecured loan when it’s riskier?
Plenty of reasons. A lot of people simply don’t have valuable assets that they can use as security to get a loan. If they own a property, it’s likely to be pledged to their mortgage company and they might not have anything else to put up instead. But they may well have a steady income with enough left over every month to support some debt. That’s why a lot of consumer lending is unsecured, including credit cards and personal loans. The same goes for smaller companies – most are service businesses, relying on the knowledge and skills of their employees to earn their income. They own very few physical assets but they might well be comfortably profitable and able to take on some debt. However, if they want to borrow, it’s likely to be unsecured.
The most important point to note about unsecured lending is that the lender must know enough about the borrower’s credit history to be able to assess how risky the lending will be. People with no assets and no credit history are going to find it very hard to get any type of loan.
Another plus point for unsecured lending is that it can be a quicker and less labour-intensive process for the lender. This is because there is no need to put in place a legal claim over the borrower’s assets and have them valued before the loan can be released.
Even so, isn’t secured lending always safer than unsecured lending?
It depends on how many loans the borrower already has and what type of debt is involved. Secured loans have a ranking of their own, from “senior” to “junior” or “subordinated”. This means there’s a pecking order for lenders to get their money back if things go wrong – "senior debt" is paid first and the rest comes after. If the borrower defaults and there is only enough money to repay the "senior debt" once the assets are sold, lenders further back in line could face losses even though their loans were secured.
How do secured lenders protect themselves from losses?
Secured lenders protect themselves by making sure they understand who else has lent money to the borrower and where everyone stands in the pecking order. The further back in the queue a new lender is, the higher the interest rate the lender will ask for to compensate them for the extra risk they are taking.
Additionally, secured lenders make sure they leave themselves plenty of headroom against the value of the asset that is being used as security. Many finance providers will not lend more than 65%–70% of the value of an asset, leaving a large cushion to protect them from the possibility of losing money if the loan goes bad.
Is it critical to get the valuation right?
Too right. Being a successful secured lender depends on lots of things, but a very big one is the valuation that you put on any assets that will be used as security. If your valuation is too high, you won’t have as much of a cushion as you’re expecting. Let’s say you value a property at £200,000 for security on a loan and lend 70% of that. The loan will be £140,000. However, if the property is actually worth only £170,000, your loan will not be at 65% of £200,000; instead it will be at 82% of £170,000 – a much riskier proposition. Using a cautious valuation as a basis for your loan-to-value calculation is critical.
OK, but lots of asset prices are shooting up. A toppy valuation today will look fine in a year or two’s time.
That might well be right, but what if prices stop rising, perhaps if interest rates go up? An aggressive loan-to-value calculation will quickly cause headaches if asset values start to dip. That’s why lots of lenders put extra conditions on their loans (called covenants). Covenants specify to the borrower what conditions the borrower must continue to meet. For example, there might be a covenant that says that the borrower’s rental income must cover loan payments by at least 1.5 times. If their income falls below that level, the covenant might allow the lender to take additional security.
Written by Andy Davis
Former Writer for the Financial Times
Andy Davis is a UK-based writer on investment, finance and business. He was previously a journalist on the Financial Times for 15 years where he held a series of senior roles including editor of FT Weekend.
He is the author of several research reports on non-bank finance for small businesses published by organisations including Nesta, the Centre for the Study of Financial Innovation and the ACCA. His most recent report, From Peer2Here: How new-model finance is changing the game for small businesses, investors and regulators was published by the CSFI in May 2017.
Andy holds angel investments in several alternative finance providers as well as being a long-term lender via numerous P2P platforms. He is a contributor and investment columnist for Prospect, the monthly current affairs magazine, and is a previous holder of the Wincott Award for Personal Financial Journalist of the Year.