Question

Explain why unsecured loan is riskier than a secured loan and discuss what mechanism banks and other lending institutions put in place to mitigate against the high risk involved (20 points)

Answer 1

Secured loan is a loan granted against a collateral, which could be a car, house or property. In case the borrower defaults, the bank can take possession of the asset pledged as collateral and sell the same in order to recover the amount lend.

But in the case of an unsecured loan, there is no asset or property against which the bank is secure. Therefore, such a loan is labeled as “high risk”.

However, a bank and other lending institutions take a number of steps to protect itself from such high risk such as:

1. Require borrowers having high credit scores. This will grant the lenders the security to grant unsecured loans to the borrower as they feel the borrower has a good track record in repaying debt.
2. Higher interest rate.
3. Require the borrower to have a co-signer who will repay the debt in case the borrower defaults.
4. Require the borrower to have a stable employment,
5. Specifying the age of the borrower such as age above 21 or 25 and below 60 years of age.
6. The bank can commission loan recovery agents for recovery of the defaulted loan.