There are only two major categories that sort all types of debt, secured debt and unsecured debt.
Applying for a secured loan means that you’ll need to put up some type of collateral (it depends on what type of loan you want) and applying for an unsecured loan means you won’t need to put up any type of collateral.
Generally speaking, a secured loan is easier to be approved for as the collateral will protect the lender if you were to default on your loan. To be approved for an unsecured loan there are more criteria that you must meet, as the risk a lender takes on is greater. Here is a breakdown of the differences between secured debt and unsecured debt.
What Is Secured Debt?
Secured debt is debt that is collateralized by a valuable asset, such as a car or house. If you default on the loan, the lender can repossess the collateral and sell it to recoup their losses rather than going after you to collect the outstanding debt.
Types Of Secured Debts
The following are common examples of secured debt:
In a majority of cases, the biggest secured debt the average person has is a mortgage. That is the kind of loan that finances the purchase of a house. This type of debt is secured by the house that you are purchasing. What this means is that if you become unable to make your mortgage payments your house can legally be seized by your lender and then sold to pay off the remainder of your mortgage.
An auto loan is a type of loan that is used to cover the purchase of a vehicle. In this case, the car would collateralize the loan. If you default on the loan payments, the lender can repossess the car and sell it to cover any losses.
When you take out an auto loan, you’re required to pay back the loan amount, with interest, through installment payments over a specified period of time.
Home Equity Loans
If you own a home and have accumulated equity in it, you can borrow against the equity. You’ll receive the money in one lump sum and must pay it back along with interest over the loan term.
With this loan type, your home serves as collateral. As such, you risk losing your home if you fail to keep up with loan payments.
You may qualify for a competitive interest rate because the value of the home that backs the loan reduces the risk for the lender. Generally speaking, you need at least 15% to 20% equity in the home to qualify, though this may depend on the lender and your financial health.
Secured Credit Cards
Traditional credit cards are unsecured, which means there is no asset of value backing the credit account. A secured credit card, on the other hand, is backed by a deposit, which serves as the credit limit. This makes a secured card less risky for the creditor.
If you fail to make the minimum monthly payments, the creditor can tap into the security deposit to take back what they’re owed.
What Can Be Used To Secure A Personal Loan?
Most secured loans are backed by the asset they’re being used to finance. For instance, an auto loan is collateralized by the vehicle, and a mortgage is secured by the house.
That said, there are all sorts of different valuable assets that can be used to secure a personal loan, including the following:
- Stocks and bonds
- Cash in a bank account
- Insurance policy
- Precious metals
- Future paycheques
What Happens When You Can’t Repay Secured Debts?
If you’re unable to make your payments, the lender will seize your asset to recover the money they’ve lent you.
If the amount that your lender is able to sell the asset for does not cover the total cost of your loan, you’ll be liable for the difference. The lender may take action by selling your debt to a collection agency or by garnishing your wages.
Can Secured Debt Be Forgiven During Bankruptcy?
In the case of bankruptcy, secured debt is normally not discharged. If you need to file for bankruptcy and you have a mortgage and want to keep your home you’ll be required to continue making payments. If you file for bankruptcy and you have any other form of secured debt you’ll also need to continue to make payments on those or sell the asset that is acting as collateral.
Advantages Of Secured Debts
There are plenty of reasons why you may want to apply for a secured loan, including the following:
- Easier to get approved for. Secured loans pose a smaller risk for lenders because they can repossess the collateral if you default. As such, lenders are more willing to extend a loan, even if your credit and finances are not as strong as they might need to be to get approved for an unsecured loan.
- Costs are often lower. Not only are secured loans easier to get approved for, but they may be more affordable, too. The lower risk they pose for lenders means you may be able to snag a lower interest rate, which can bring down the overall cost of your loan.
- Potential tax benefits. Some secured loans, like mortgages, come with tax breaks. For instance, you may be able to deduct interest payments from your mortgage when you file your income taxes.
Risks Of Secured Debts
Along with the perks of secured debts come a couple of drawbacks to consider as well:
- Risk of losing collateral. If you stop making loan payments, your lender may start the process of repossessing the collateral you’re using to secure the personal loan.
- Less flexibility in how funds are used. You may not have the flexibility to use the funds from a secured loan as you see fit, especially if the loan is being used to finance a specific asset, such as a car. That said, home equity loans are an exception to this rule.
What Is Unsecured Debt?
Unsecured debt is debt that is not backed by a valuable asset. The lender does not have anything to repossess if you default on the loan, which makes these types of debts riskier for the lender. Given the added risk, unsecured debt is more difficult to get approved for and may come with higher interest to offset this risk.
Types Of Unsecured Debts
The following are common examples of unsecured debt:
While some personal loans may be backed by collateral, most are not. The lender will give you a lump sum that must be repaid by the end of the loan term, along with interest. You can use the funds of a personal loan to cover the cost of just about anything, at the discretion of the lender.
Credit cards come with a credit limit that you can spend up to, but not exceed. You’re only charged interest on balances carried over from one month to the next. If you pay your bills in full each month, you can avoid paying interest, which tends to be high on credit cards compared to other types of debt.
Credit cards are handy when you have an urgent expense to cover and don’t have time to go through a loan application and approval process. Keep in mind, however, that spending close to your credit limit will increase your credit utilization ratio, which can negatively impact your credit score.
If you’re unable to cover the cost of college or university tuition, a student loan can help finance your education. If you qualify for a student loan, you can use the funds to pay for a big chunk of post-secondary education costs.
You won’t have to make any loan payments while in school. Once you graduate, you may be given a grace period of a few months before loan payments are required. But interest will still accrue during this time.
Soon after graduation, you must start paying back what you borrowed.
What Happens When You Can’t Repay Unsecured Debts?
While the consequences of defaulting on a secured loan include losing your collateral, unsecured loans also come with risks if you fail to pay up:
- Late penalty fees. Your lender will likely charge you late payment penalty fees or extra interest on missed payments.
- Negative impact on your credit score. If you’re able to make up for a missed loan payment within 30 days of the due date, your lender will probably not report the late payment to the credit bureaus. But if at least 30 to 60 days pass after your payment was due, your credit report will usually reflect the missed payment, which can negatively affect your credit.
- Debt sent to collections. If your unsecured loan payments get too far behind, the lender may get a collection agency to come after you for the outstanding loan amount.
Advantages Of Unsecured Debts
There are several perks to unsecured loans, including the following:
- No risk of losing collateral. Unlike secured debt, there’s no risk of having a valuable asset repossessed by the lender if you don’t pay back the loan.
- Flexibility of funds. Unsecured loans can often be used to cover all sorts of expenses with few restrictions.
- Faster application process. There’s no need to appraise any collateral with an unsecured loan, which can help move the application process along faster.
- Several options available. Unsecured debt can take various forms, including personal loans, credit cards, student loans, and others.
Risks Of Unsecured Debts
Unsecured debts also come with a few disadvantages, such as the following:
- More difficult to get approved for. Due to the higher risk for the lender, unsecured loans may require more stringent criteria for borrowers to meet in order to get approved.
- Higher interest rates. Again, the increased risk of unsecured loans for lenders means they often come with higher interest rates compared to secured loans. Since there’s no valuable asset to recoup, lenders make up for the added risk by charging more in interest.
- Lower credit limits. Unsecured debt may come with lower credit limits and loan amounts, which might not be enough for what you need.
- Missed payments. If you miss your loan payments, your credit score may suffer That said, the same risk applies to secured loans.
Should You Pay Off Your Secured Debt Or Unsecured Debt First?
If you carry both secured and unsecured debt, you may want to consider paying off your secured debt first. That’s because secured debt places a valuable asset at risk. If you fail to keep up with your loan payments, you risk losing your asset. By paying down your secured loans, you can protect those assets from being seized.
That said, there are a couple of different tactics to consider when it comes to choosing which debts to focus on paying off first, regardless of whether they’re secured or unsecured:
The Avalanche Method
Consider paying off the higher-interest debt first. Getting rid of the debt that you’re paying the highest interest on can help you pay less over the long run.
As you pay down the debts with the high rates, you’ll open up more of your finances to eventually repay your lower-interest debts. This can help you become debt-free sooner.
The Snowball Method
If you carry a variety of debts that range in loan amounts, consider paying off the smallest loans first, since they are typically the quickest ones to repay. Once that debt is repaid, you can then work on paying off the next-smallest loan, and so forth. The money you’re freeing up by paying off each loan one by one can then be applied to each subsequent loan until all your debt is paid off.