What Is Debt?
I.O.U.In its simplest definition, you are in debt when you owe some person or institution money. We need a refinement though. For our purposes, a secured loan is not a debt, even though money has been loaned to you.
The Secured Loan
To secure something is to make it safe. When you secure a loan, you free the lender from any risk of losing his money. That's why he's willing to lend it to you, he has no fear of loss.
Your word, your good faith, even your unfailing history of repayment do not secure a loan. What happens if you have medical emergencies, lose your job, or simply go bonkers and run off to Brazil? If, for any reason, you just don't have the money to pay the loan back? The lender loses his money, that's what.
Collateral, in its primary definition, is something that runs side by side with something else. In financial terms, collateral is property you pledge to the lender or actually give to him to hold during the course of the loan. That property is security, it's what makes the lender's money safe or secured. When you pay him back, he returns it to you.
A loan from a pawnshop is a classic example. You bring your camera to the pawnbroker. He loans you $75. When you repay him the $75 (plus interest, of course), he gives your camera back to you. If you don't repay him, he keeps your camera. You don't own your camera anymore, but you don't owe him $75 either. The loan is over.
Fine, you say, but you're not interested in hockshops and cameras. You're talking big money, $5,000, $50,000, more.
The Numbers Don't Make Any Difference.
A loan is a loan, whether it's for $5, $500, or $50,000. And collateral is collateral, whether it's a television set or a television station.
One of the most common forms of secured loan is a mortgage. Let's say I'm buying a house for $150,000. I've saved $30,000, which I use for the down payment. The bank likes my job history, my salary, and my credit record. They have confidence in me. But that confidence alone isn't enough to persuade them to lend me the additional $120,000 I need, not without strings attached. Life's too unpredictable for that. So they require me to give them a mortgage on my house, a document that generally grants them all legal rights to it if I default, that is, if I fail to make my loan payments for a specified period of time, usually about four months. The bank then has the right to foreclose the mortgage, to take possession of my house in lieu of what I owe them, sell it, and keep the proceeds or the bulk of the proceeds for themselves, thus recouping their $120,000. I've secured the loan by pledging my house as collateral. I've eliminated the risk that the bank will lose their money if they lend it to me.
Car loans work the same way. I buy a new Chevy for $24,000. I put $5,000 of my own money down and borrow the balance, $19,000, from a bank or from General Motors. To get the financing, I sign a document that gives the lender all rights and title to the car if I don't pay the loan back.
If I default in either of these cases, I lose my house or my car. That would be painful, but I would not owe money to anyone. I would not go into debt, provided I had made a large enough down payment. That is an important provision. Normally what happens in the case of a house or a car walked away from, foreclosed upon, repossessed or otherwise reclaimed by the lender, is that the lender sells off the property, deducts the amount received from the outstanding balance, and arrives at a new balance owed: the old one minus the proceeds of the sale.
Let's say that Frank, who still owes $9,000 on his Honda, is moving to another state and a new job where, among other benefits, he will have the use of a car. He's broke and under time pressure. So he turns the car over to the creditor (almost always a bank), and says, "Here, it's all yours. The loan is over.&
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