Loans

How do regular loans work?

Most of us understand how a regular loan works. Still, it's worth reiterating so that we can make the comparison later.

Unsecured loans

An unsecured loan is a loan where you don't need to put forward any collateral. In other words, there isn't an asset you agree that the lender can have if you don't repay the loan. For example, suppose that you really want a $3,000 gold chain with the Binance logo hanging from it. You don't have the cash available to you, but you will when you get paid next week.

You speak to your friend Bob. You explain to him how badly you want this chain, how it will improve your trading game by at least 20%, and he agrees to lend you the money. On the condition, of course, that you repay him as soon as your paycheck comes in.

Bob's your good friend, so he didn't leverage a fee when he lent you the $3,000. Not everyone will be so kind – but, then again, why should they be? Bob trusts you to pay him back. Another person might not know you, so they don't know if you're going to run off with their money.

Typically, unsecured loans from institutions require some kind of credit check. They'll look at your track record (the credit score) to measure your ability to repay. If they see that you've taken out several loans and paid them back on time, they might think huh, they're pretty reliable. Let's lend them some money.

At that point, the institution gives you the money, but it comes with strings attached. Those strings are interest rates. To get the money now, you need to accept that you'll be paying back a higher amount later.

You might be familiar with this model if you use a credit card. If you don't pay your bill for a given period, you get charged interest until you repay the full balance (and additional fees).

Secured loans

Sometimes a good credit score isn't enough. Even if you've repaid all of your loans on time for decades, you'll have a tough time borrowing large sums of money based solely on your creditworthiness. In these cases, you need to put up collateral.

If you ask someone for a big loan, it's risky for them to accept it. To lower their risk a bit, they'll demand that you put some skin in the game. An asset of yours – it could be anything from jewelry to property – will become the lender's if you fail to pay them back in time. The idea here is that the lender can then recover some of the value that they've lost. In a nutshell, that's collateral.

Suppose that you now want a $50,000 car. Bob trusts you, but he doesn't want to give you the money in the form of an unsecured loan. Instead, he asks that you put up some collateral – your collection of jewelry. Now, if you fail to repay the loan, Bob can seize your collection and sell it.