Secured Debt: What it is, How it Works, Example

What Is Secured Debt?

Secured debt is debt backed or secured by collateral to reduce the risk associated with lending. If the borrower on a loan defaults on repayment, the bank seizes the collateral, sells it, and uses the proceeds to pay back the debt. Assets backing debt or a debt instrument are considered as a form of security, which is why unsecured debt is considered a riskier investment than secured debt.

Understanding Secured Debt

Secured debt is debt that will always be backed by collateral, which the lender has a lien on. It provides a lender with added security when lending out money. Secured debt is often associated with borrowers that have poor creditworthiness. Because the risk of lending to an individual or company with a low credit rating is high, securing the loan with collateral significantly reduces that risk.

For example, let's say Bank ABC makes a loan to two individuals with poor credit ratings. The first loan is backed by collateral whereas the second loan is not. After three months, both borrowers cannot make payments on their loans and default. With the first loan, backed by collateral, the bank is legally allowed to seize that collateral. After they do, they sell it, usually at auction, and use the proceeds to pay back the outstanding portion of the loan.

In the second loan, where there is no collateral backing it, the bank has no collateral to seize to pay back the outstanding debt. In this case, they will have to write-off the loan as a loss on their financial statements.

When a loan is secured, the interest rate that is offered to the borrower is often much lower than if the loan was not secured. Sometimes, when a loan does not necessarily require collateral, such as a personal loan, it can be in the interest of a borrower to put up a form of collateral to receive a lower interest rate. They should only do this if they are sure that they can continue to pay back the loan or are willing to lose the collateral if they cannot.

Priority of Secured Debt

If a company files for bankruptcy, its assets are listed for sale to pay back its creditors. In the payback scheme, secured lenders always have priority over unsecured lenders. The assets are sold off until all secured lenders are fully paid back, only then are unsecured lenders paid back.

If the assets are sold and there are not enough proceeds left to pay back unsecured lenders, they are left at a loss. If there are not enough proceeds to pay back the secured lenders, depending on the situation, secured lenders can go after other assets of the company or individual.

Examples of Secured Debt

The two most common examples of secured debt are mortgages and auto loans. This is so because their inherent structure creates collateral. If an individual defaults on their mortgage payments, the bank can seize their home. Similarly, if an individual defaults on their car loan, the lender can seize their car. In both cases, the collateral (the home or the car) will be sold to recoup the outstanding debt.

For example, Mike takes out a $15,000 car loan from a bank. The loan is a secured debt because the car acts as the collateral that the bank can seize if Mike defaults on his loan repayments. After two years, there is still $10,000 left to pay on the loan, and Mike suddenly loses his job. He can no longer make the loan payments and so the bank seizes his car.

If the current market value of the car is $10,000 or more, when the bank sells it and collects the proceeds, it will be able to cover the remaining debt. If the market value of the car is less than $10,000, say, $8,000, the bank will cover $8,000 of the outstanding debt but will still have $2,000 of the debt remaining. Depending on the situation, the bank can go after Mike for this remaining $2,000 in debt.