What it is:
How it works/Example:
Let’s assume you would like to borrow $100,000 to start a business. Even if you have an excellent credit rating, a bank may be reluctant to lend you the because it may be left with nothing if you default on the . Thus, although banks may attempt the lengthy and expensive process of suing you in that circumstance, the bank may require $100,000 of security -- in order to lend you the money. This collateral might consist of financial instruments, houses, , or even objects such as art, jewelry or other items. You might also pledge your business receivables as well. When you pledge these assets, you are collateralizing the loan.
If you in fact default on the loan, the loan agreement gives the the right to seize, then sell the collateral in order to recover any outstanding balance.
For individuals, cards are the most common example of unsecured loans. There is no collateral backing up your Visa bill that Visa can seize if you don't pay your bill.
Why it matters:
If a deposit you made, a lien on your house, the title to your car -- that has a secured . If the creditor has no ability to claim some of your assets when you don’t pay (this is often the case with cards), the creditor has made an unsecured loan. If you have borrowed from a bank, the bank may ask you for as a way of securing the loan.
Unsecured loans are riskier than secured because the lender does not have the ability to seize an right away if a borrower fails to repay the . Creditors may of course sue to obtain access to accounts or other assets if the borrower has not paid, but that is more expensive than requiring collateral up front. Regardless, this lack of security increases the creditor’s risk, which in turn increases the interest rates on unsecured loans.