What Is a Secured Note?

A secured note is a type of loan that is backed by the borrower's assets. If a borrower defaults on a secured note, the assets pledged as collateral can be sold to repay the note.

Understanding Secured Notes

Two types of notes used to extend credit from one entity to another are unsecured notes and secured notes. With an unsecured note, the borrower does not pledge any assets as collateral, so it must pay the lenders a higher interest rate in order to compensate them for the increased risk.

On the other hand, secured notes are backed by collateral, providing the lender increased assurance of return on the loan amount and interest. The nature of the collateral will vary, depending on the type of loan arrangement involved. Examples of collateral that can be pledged include real estate, stocks, bonds, jewelry, artwork, automobiles, etc. The secured feature associated with secured notes decreases the risk associated with secured notes, so lenders earn a lower interest rate than they would earn with riskier issues such as unsecured notes. In the event of a business liquidation, secured creditors are paid first, sometimes partially through the return of the property. As unsecured creditors have no collateral or security over the company’s assets, they rank after secured creditors in the event of a liquidation.

How Secured Notes Work

A secured note is guaranteed by an interest in an asset that is worth at least the amount of the note. If you have a mortgage or an automobile loan, you are the holder of a secured note. In the case of a mortgage, you hold a secured note with your home pledged as collateral. A mortgage loan is a loan secured by real property through the use of a mortgage note which serves as evidence that the loan exists. During the period of time that the mortgage note holders make monthly payments on the mortgage, the lender retains an interest in that property. Once the note is paid in full, the lender relinquishes all claims on the real estate, and the borrower fully owns the property without any type of claim against the property. If a debtor fails to make mortgage payments, the lender may choose to exercise its rights to seize and foreclose on the property pledged as collateral.

In the case of an auto loan, the vehicle that is purchased with the borrowed funds is used as collateral. This means that the lender can repossess the debtor’s vehicle if the borrower stops making loan payments.

A secured note will also specify the terms of a loan agreement including the interest rate, typically a fixed rate, for the duration of the loan. The fixed interest rates on a secured note mean that the same interest rate is applied to the outstanding balance of the loan from the beginning date to the maturity date when the loan is settled in full.

In business, a secured note might be issued by a corporation that provides private debt and equity financing to a company looking to expand its business. If the business expansion is unsuccessful, the lender will take the assets that the company pledged to secure the loan, which might include real estate and equipment.