“Collateralized” and “secured” are common terms in the banking world used to describe a loan that has some material asset backing it up. The most obvious example is a home mortgage: both the house and the property it sits upon have an intrinsic value, and this value is used to give the banker a secure feeling that the bank will get its money back, even if they must foreclose on the mortgage to do it. A secured loan, such as a mortgage, is basically a complicated gamble. Let us take a $400,000 mortgage as an example:
· You, the home buyer, are betting that you can make 360 consecutive monthly payments of $4000. If you win the bet, the bank gives you the house.
· The bank is betting $400,000 that you will default on the loan and not be able to make the 360 payments. If they win, they keep the house AND all the money you have paid them to that date.
Obviously, it is better to be the bank than the home buyer in this situation. The bank is basically going to win no matter what; if you default, they at least get the house. If you make all your payments then they get to keep all the money you paid them. And this is all for what they made sound like an “easy loan”.
You might be asking yourself, “If the bank stands to win anyway, why do they require a big down payment on a home loan?” Quite simply, the down payment increases the odds in the bank’s favour in two ways:
1. Suppose, for instance, that you have paid $40,000 into the mortgage, and then defaulted. The bank forecloses on your house but can only auction it off for $300,000. They have therefore lost $60,000. If they had collected a $60,000 down payment, they would have at least made their money back on the deal.
2. Forcing the home buyer to make a substantial down payment increases the home buyer’s stake in the loan. If you took out a $400,000 mortgage with no down payment, you could walk away and let it foreclose a year later without suffering too great of a loss. However, if you had made a $60,000 down payment on that house you would be much less likely to walk away and let that $60,000 go down the tubes.
In the long run, banks stand to make the most money if you see your loan through and make all the monthly payments. Look at the mortgage example above: $4,000 times 360 months = $1,440,000. That would be over $1 million in pure interest the bank would pocket! That’s certainly a way for them to get easy money isn’t it? Although we used the example of a home mortgage, this would be true of virtually any secured loan, such as a car loan.
Taking a much different approach to lending are lenders of small loans such as bond loans, short-term loans, unsecured loans and payday loans. The beauty of these creations is that you are not tied down with long-term debt that takes years to pay off. The existence of these loans in the market provides quick and easy loans to get people through the tough times, all for a reasonable fee that is disclosed up front. No long-term debt, no huge interest payments, no ongoing fees and you can be the one pocketing the easy money instead of the banks. They are certainly a better alternative when you are trying to live within your means.