This article first appeared Lets Crowd Smarter.
Secured loans are backed by collaterals and typically have lower risk. New Union, Crowdo and Silver Bullion offer secured p2p loans. Capital Match, Funding Societies and InvoiceInterchange offer invoice crowdfunding, which is a form of asset-backed financing. What are the risks in secured lending and asset-backed financing? How should investors think about their risks?
Read Also: Three Key Risks of Peer-to-Peer Lending
What Are Secured Loans?
Unlike unsecured loans, a secured loan is backed by a collateral, such as property, precious metal or vehicle. If the borrower is unable to repay the loan, the lender can liquidate the collateral to recover the money owed. If the proceeds from the sale of the collaterals are insufficient to recover the owed amount, the lender is still obliged to make up for the shortfall.
In invoice financing, unpaid account receivables are sold to third parties to raise cash. It is similar to secured lending because the unpaid account receivables are like collaterals that have cash value.
Is Secured Lending Safer?
Secured lending is usually safer than unsecured lending because the collateral provides an additional level of protection against loan default. All things being equal, the interest rates offered for secured loans are often lower than unsecured loans, reflecting the lower risk.
However, investors should also understand how loan collaterals are managed. A secured loan without proper collateral management can be as risky as an unsecured loan.
What To Watch Out For In Secured Loans?
Firstly, the type of collateral matters. Ideally, the collateral can be easily sold without losing much of its value. A good example will be gold. Gold is respected throughout the world for its value and there is always a ready market for it.
Secondly, collateral valuation is important too. Typically, this requires opinions of specialist appraisers. For example, if jewellery is pledged as collateral, the appraiser will need to estimate its gold purity in order to determine its value. Valuation of gems such as diamond is also quite complex.
Thirdly, investors should pay attention to how the loan collateral is secured. The safest option is for the lenders (or lending platform) to physically hold on to the collateral. For example, Silver Bullion offers secured loans to borrowers who pledged their precious metals as collaterals. The collaterals are safely held in its vault and can be liquidated if the loan defaults. For invoice financing, investors should pay attention to whether the invoice is notified and whether payments are made direct to the invoice buyers or the lending platform.
Fourth, look for a reasonable loan-to-value ratio. Despite the best efforts of the lending platform, the liquidation value of the collateral may still be lower than expected. This may be due to a drastic fall in the prevailing prices of property or precious metals. Therefore, a good buffer between the loan value and collateral value would give some protection against loan loss. In invoice financing deals, the LTV ratio is known as the advance ratio.
Finally, don’t forget the borrower’s credit risk! While the collateral helps mitigate the risk of loan loss, it is always important to lend to creditworthy borrowers.
Secured Or Unsecured?
Secured loans offer safety and lower return, while unsecured loans are risky yet offer higher return. Ultimately, investors need to make a trade-off between risk and return. What’s your preference? We would love to hear your thoughts!
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