No matter what the investment vehicle, whether it is CDs, money market, stocks, bonds, or private investment lending, the private investor must weigh the polarities of private investment risk versus security. ALL investments carry with them some element of risk. Since there is no such thing as a risk free investment it behooves us to know how increasing security works to minimize risk. Let’s start by viewing the Lender Risk Table below.
Private Investment Risk versus Security
In the table above there are four categories of risk. On the left are investments that put the private investor’s principal at greatest risk. On the right are the investments with the least risk for the investor.
No Collateral Loans
On the left of the chart is the riskiest of loans. The loan made with no collateral. Lenders can make money on no collateral loans as is exemplified by the credit card industry. Even during extremely economically distressed times, credit card companies make billions of dollars in profits from loans made on nothing other than a person’s promise to pay. In a no collateral loan there is no collateral for the lender to take possession of should the borrower not fulfill the promise. With no collateral loans the lender’s recourse, in the event of non-payment, is limited and, therefore, interest rates can be substantial to compensate for the higher levels of risk.
Though most people do not think of investment in the stock market as a loan, the reality is, a stock purchase is a loan to the company from whom the stock was purchased for the purpose of capitalization for the company. Stocks are an example of unsecured lending. When one purchases a stock, one has no collateral and no guaranty that the loan will return profitable earnings. A stock can, in fact, lose value and is, therefore, another prime example of an unsecured loan.
Loans on Depreciating Collateral
Loans secured by collateral that is depreciating carry a minimized risk as compared to no collateral loans. Loans for automobile purchases are the prime example of depreciating loans. Everyone knows that the value of an automobile will be less the minute it is purchased and driven off the lot then it was at the time of purchase. The auto loan is based upon purchase price not upon value. Just like in no collateral loans, lenders are making fortunes lending on depreciating collateral. The risk to the lender is somewhat minimized because there is some collateral and in the event of borrower default, the lender can reclaim the collateral. The risk to loss of capital still remains high because even though the collateral can be redeemed, it is almost certain to have less value than the remaining principal on the loan.
Loans on Appreciating Collateral
Loans secured by collateral that is appreciating further minimize the risk to the lender. Real estate is generally considered an appreciating asset. Though real estate can depreciate as we know during economic downturns, over time real estate is considered to be a reliably appreciating asset. Appreciating collateral is considered to minimize risk because the value of the collateral is likely to increase over time. If the borrower defaults on a loan secured by appreciating collateral, the lender can reasonably expect to take possession of an asset whose value exceeds the amount of the principle. Therefore, it is possible that foreclosing on an appreciating asset could prove to be more lucrative than the mere collection of interest and payments.
Probably the least risky investment is saving in FDIC insured accounts such as CDs, Money Market accounts, and just your regular passbook savings. FDIC insured accounts insure that the investor will always be able to redeem the principal and interest as long as the principle does not exceed $250,000. Even though these FDIC insured accounts minimize risk they do not necessarily make for good investment vehicles because earnings are very low. Generally, interest paid on these minimal risk accounts is less than inflation. Because the interest paid is less than inflation, the investor loses financial ground rather than gaining.
When considering private investment risk versus security, the risk factors for private investment lending backed by secured collateral provide reasonable risk while offering good return on investment.