The Disadvantages of Asset-Based Lending
Borrowers can place collateral to secure financing through asset-based lending programs. Common collateral includes homes, cars, businesses and even stock or savings accounts. Asset based loans are desirable because they offer the borrower a way to secure the loan and reduce the interest rate. Particularly for low-credit borrowers, these loans can be the only option to get financing at a good rate. With asset based loans, though, the borrower assumes the vast majority of the risk.
Loss of Asset
The worst case scenario with any asset based loan is losing the asset in case of default. When you place a car as collateral, for example, you are giving the car title to the lender. You will not get the car title back until the loan is paid off. If you violate any of the terms of the loan, the lender can come and seize your car. This will usually occur without notice. It is not uncommon for an impound specialist to show up while you are at work or school and take your car away without any warning.
Risk of Low Valuations
The amount of financing you get through an asset-based loan is dependent on how the collateral is valued. If the value of the collateral goes up over time, your loan limits will not go up. As a result, you will have an asset collateralized for much lower than it is actually work. This means, for example, you could have placed a $300,000 home on the line and only received $230,000 in financing. The lender is in a much stronger position than you, the borrower, at that point. In contrast, with an unsecured loan where no collateral is used, the borrower maintains the upper hand throughout the process.
Negligible Effect on Credit
Secured loans are not the fastest way to build a credit score. An unsecured loan will rebuild credit much faster because it appears as additionally financial strength on a person's or business's balance sheet. With a secured loan, the person has no more financing than they had previously because they are placing the value of an asset down in trade for the new funds. Businesses in particular benefit more from unsecured loans because they appear as a strengthened financial position to other lenders and investors. This may not matter as much to individuals, but credit scores are always important across all areas.
One risk of continually placing assets on the line in return for financing is over-mortgaging your own assets. This means that you will end up owing more on the loans than you have in equity. If the value of the assets drops, you may owe more on the loans than the assets are worth if you were to sell. This occurs in large numbers when real estate values drop. People who have taken out second mortgages based on a high value of the home may end up "upside-down" on the mortgage. This means if they sell the house they would end up having to pay additional money to the mortgage company beyond what they sold the house for. Getting into too much debt is an easy trap to fall in with asset based lending.