What Is a Covered Loan?
This article will look at covered loans and why most lenders prefer them, and whether it’s a good idea to take them.
Simply put, a covered loan is protected by collateral assets, usually, a piece of property with equal or more monetary value, to act as security in case you fail to repay the loan. The goal of the covered loan is to minimize the risk to the lender. Covered loans are often used to finance more significant transactions, such as homes and cars.
By comparison, unsecured loans do not use collateral. Instead of reducing the risk for the buyer, these loans reduce the risk of the borrower, but the tradeoff is relatively high monthly payments and smaller loan terms. Choosing between covered and unsecured loans boils down to a borrower’s options and whether they have the financial ability to save money.
Most people will accrue both covered and unsecured loans in their lifetime, which include credit cards. If you’re a borrower, your goal is to figure out which type of loan to use for any given situation.
Understanding how a covered loan works
The best way to understand covered loans is to think of a typical auto loan. In exchange for financing your new car, the lender uses collateral to protect their money. For most borrowers, the collateral would be the new car as security. If you, as a borrower, fail to make your monthly payments on time, the lender can acquire your car, sell it, and use the remaining proceeds to mitigate their financial loss and reimburse themselves.
In the same vein, home equity and mortgage loans are also used as collateral. You can also obtain covered credit cards and personal loans – these would require a cash deposit.
The collateral doesn’t have to be a house or a car. Any high-value item can be used as collateral. This includes inventories, invoices, and expensive equipment.
All of these loans have the same thing in common – the lender retains the ability to possess your valuable property legally if you fail to pay your loan as agreed. The obvious advantage to the borrower is quick and easy access to a large sum of capital. Most lenders are simply unwilling to lend millions of dollars to help buyers purchase a home unless they put up some collateral.
Like most investors, the primary purpose of lenders is to minimize their risk. Since covered loans are perceived to be less risky, the interest rates are often much lower if they had no collateral. If you have secured loans and credit cards, making a cash deposit right away may allow you to improve your credit if unsecured credit is not available to you.
Different types of collateral for covered loans
Most secured loans use the following types of collateral:-
Mortgage for Property: This loan is secured against the property that is being financed. If the borrower fails to clear their dues and default, the property will be foreclosed by the borrower and auctioned off, with the lender using the proceeds to reimburse themselves.
Real Estate Financing: Most individuals and businesses can use their property to secure a loan. Lenders prefer real estate because it retains value (and grows) over time. Although there are many perks of using real estate, it also comes with a very high risk. You could, for example, lose your primary place of residence if you default on the loan.
Auto Loan: This type of loan is secured against a car, and the consequences for defaulting are the same as above.
Investment Financing: Investments such as stocks can be used as collateral to open up covered loans such as credit cards. Most investments are liquid assets that can be sold relatively quickly to repay lenders. Traditional banks favor this type of collateral. Note that the value of investments can fluctuate depending on market conditions. You may not be able to secure financing if your reinvestments decline below the amount you are trying to borrow.
Bridge Loan: This loan is secured against a property that is up for sale to facilitate the purchase of a new property. The loan gets repaid once the property is sold. The most common use scenario is when buy-to-let developers try to obtain financing for renovation projects so they can sell the property or rent it out. Once the term ends, the loan is repaid or refinanced as a different type of loan.
Invoice Loan: An invoice loan is given to businesses against amounts that are due from clients. This loan is mostly given to businesses to improve their cash flow to pay their employees, vendors, and reinvest the money. The only downside is that you will be charged with interest rates and fees. In other words, you could be earning less money if your clients paid directly to you.
Inventory Finance: This is a loan that is given to businesses against inventory that they haven’t sold yet and have no plans for selling in the near future. Defaulting on these loans will result in the seizure of the inventory.
Business Equipment Financing: This is a relatively low-risk type of collateral, especially if you’re in a manufacturing industry. It’s safer to put up business equipment than your family home or other property. The only downside is that business equipment depreciates in value over time. If you own machinery that has undergone wear and tear, you’ll have a hard time using it to secure financing. Most lenders will do their homework when it comes to the state of the business equipment before releasing finances.
Cash Loan: If you have plenty of disposable cash lying around in your account, you can use it to open a covered loan. Most lenders favor cash as a form of collateral because it is relatively easy to acquire in case the borrower defaults. This may result in much lower interest rates for the borrowers.
The advantages of covered loans
Although you have much riding with covered loans, the risks are lower in case of foreclosure of your property or seizure of your assets. Provided that you’re in control of your finances.
Since the interest rates are much more manageable, it’s easier to pay them back compared to unsecured loans. More importantly, the credit rating requirements are usually more flexible. In other words, it is generally easier to secure covered loans than unsecured loans.
It is also possible to borrow very large amounts and pay them back over a long period. For a business, personal assets may be used as collateral to provide necessary cash flow and power its operations during its early years.
Also note that covered loans are governed by the Financial Conduct Authority, which provides a semblance of protection to borrowers and eases any anxieties.
The best candidates for covered loans
If you have a guaranteed income favorable to your debt-to-income ratio, we recommend going for this route. However, if your job or business isn’t stable, you should not get into covered loans until you’re absolutely certain you can pay a certain minimum amount to the lender throughout the loan.
Small businesses can also benefit from covered loans because they can be very flexible to them. One example is business directors, who often give up their personal assets as collateral to secure cash flow. Industries that habitually receive bulk orders and require financing in the interim period to facilitate those orders can also benefit. However, you should be well aware of the risks involved if you end up defaulting.
In general, businesses and individuals with a good financial foundation and assets should benefit from covered loans. The loans are generally more affordable to pay off and flexible.
What are the consequences of defaulting on covered loans?
The best course of action is to make timely payments on your covered loan until your collateral asset becomes yours to claim. However, if you stop making timely payments and end up defaulting, the lender will have the right, as per the agreement you signed, to take possession of the collateral with or without your approval.
This is why it’s very important to review your agreement carefully when you take out a covered loan or line of credit. In most cases, lenders want you to succeed and are more than happy to give you a few more days to clear your dues. For instance, they won’t foreclose if you were late by a few days or a few weeks. Typically, your lender may impose a late fee, but it won’t result in foreclosure.
You should, however, be aware of when and how foreclosure may happen. Review your agreements with any other type of secured loan, whether it is an auto loan or a credit card loan.
Another problem with defaulting on secured loans is the negative impact on your credit score. This will tank your credit score and affect your credit history for seven years. However, the consequences for defaulting on a secure loan don’t just end at the loss of your credit score. You may lose your car, home, or any other assets you’ve listed as collateral, including any cash deposits.
Worse still is the fact that you may have to cover the remaining balance if the collateral doesn’t cover your entire debt. In other words, defaulting on secured loans is one of the worst financial losses for an individual or business. There is simply too much on the line for anyone who’s taken out a covered loan if they don’t have their finances in order.
Comparing covered loans with unsecured loans
Uncovered loans, better known as unsecured loans, don’t require collaterals. Common examples of unsecured loans include personal loans, student loans, and credit card loans. In this case, the only assurance lenders have of you repaying the debt is keeping your word and protecting your credit score. For this reason, unsecured loans are perceived to be high risk for lenders and, hence, the higher interest rate.
Most borrowers will need to demonstrate a high credit score and credit history to qualify for unsecured loans. This isn’t to say that the interest rates would be any lower. The average mortgage rate will be lower than what you pay for your credit card in most cases. It’s worth noting that since you’re not risking any collateral assets with unsecured loans, you are potentially on the hook for very high-interest debt that could snowball into a bigger problem later on if you don’t take care of it right away.
Defaulting on an unsecured loan
Borrowers who fail to repay their debt have to deal with bad credit scores for several years. Just because they won’t be losing any collateral doesn’t mean that the consequences are easy to absorb. The effect of defaulting on unsecured loans will seriously damage your credit and your ability to obtain financing until you repair them.
As a rule, paying past the due date or making payments after 30 days will hurt your credit score. These records will not be deleted until another seven years.
Another thing to worry about is the legal consequences. The lender has the right to sell your account to a debt buyer or pursue this in a legal court. This information will be a part of your credit history as well. Civil judgments and collections stay on your credit record for seven years. If this was a major financial problem, then future lenders will probably abstain from giving any credit to you.
Which loan should you obtain?
The reason why it’s sensible to borrow covered loans, despite the high risk to borrowers, is the relatively lower rates. It’s easier to pay them if you properly manage your finances. Unsecured loans do not put your assets at risk of being possessed by your lenders, but they can be more difficult to pay off due to the higher interest rates.
In most cases, choosing between covered and unsecured loans is not up to the borrower. Home and auto loans are usually covered. One very effective way to rebuild your credit score is to use a secured credit card. This will put you in a position to get approved for an unsecured loan.
But what should you do if you’re planning to remodel your house or a small DIY project? This can be a slightly more complicated choice. You could go with an unsecured personal loan to mitigate your risks or take out a Home Equity Line Of Credit (HELOC).
The best way to decide is to compare your interest rates, fees, and other requirements. Note that the HELOC route has its fair share of risks, but it gives you the ability to borrow what you need. Compare this to unsecured personal loans where you have to borrow a specific amount decided by the lender. You’ll have to pay back this amount even if you don’t end up using it all for your remodel project. With that said, if the difference in interest payments is minimal and you’re not in the mood to put up your primary residence as collateral, a personal unsecured loan may be a better option.
We recommend getting in touch with a financial advisor before you borrow a large sum of money. Your financial advisor will provide you with more accurate information based on your current financial position and interest rates.
