If you are looking to get out of debt, you may have wondered about some of the terminology used to describe your debt. The types of debt available to consumers fall under two main categories: secured debt and unsecured debt. So what’s the difference? On a basic level, the difference between secured debt and unsecured debt boils down to whether or not the debt is backed by collateral (something of value that can be taken as security in the event the debt is not repaid.)
Knowing the difference between the two types of debt is important for borrowing, for prioritizing debt during payoff, and for making sure you don’t lose any assets or collateral associated with your debt.
Secured and Unsecured Debt — An Explanation
When a creditor loans money, that lender is taking a risk. Even if you have a great repayment history and credit score, there is always a chance that circumstances could change and you won’t pay the debt back in full. On a smaller debt, this is less of a risk for the creditor, but when you are borrowing a large amount of money, the risk is greater.
Lenders have several ways to protect themselves against this risk. One way is to offer secured debt. Typically, with a secured debt, the property or item you are purchasing with the loan acts as collateral, securing that debt. If you don’t pay back the loan as agreed (default), the lender has the right to reclaim the property as payment against that debt. The risk of default for the lender on secured debt tends to be lower since the borrower has more to lose by not repaying the debt. For this reason, some types of secured debt can be easier to obtain (one exception may be a home mortgage). Also, because there is less risk for the lender, interest rates are often lower for a secured debt.
Common types of secured debts include:
- Home mortgages
- Car loans
- Boat or other vehicle loans
- Specific secured credit cards. With secured credit cards, the creditor may require an amount of money to be deposited as collateral against the card, thereby securing the risk when you borrow money through that card. These types of credit cards are typically used for those with poor credit or who have not established credit previously.
In the case of higher-value secured debt (such as vehicles or homes) the creditor will often require that the collateral is insured to maintain its value. By protecting the collateral, the value is secured for the creditor. For example, a mortgage lender will typically require that the borrower maintain homeowners insurance.
Repayment terms on secured loans can be less restrictive — there are typically less fees, more flexible terms and longer grace periods for repayment before incurring penalties.
With an unsecured debt, there is no collateral, and the lender doesn’t have the right to claim any items you purchased with the borrowed money. If the borrower defaults on this type of debt the lender may initiate a lawsuit to collect what is owed. Unsecured debts include:
- Credit cards
- Store cards
- Payday loans
- Medical bills
- Student loans
- Court ordered child support
Creditors issue funds for unsecured debt based solely on the borrower’s credit report and promise to repay. For this reason, there is typically a higher interest rate charged for unsecured debt. Requirements for credit score and debt ratio may be stricter, and it may be more difficult to obtain if an individual has poor credit. Because there is no collateral to maintain, there are no insurance requirements for unsecured debt.
While they can’t take back your collateral as repayment for your debt, the lender may take other actions to get you to pay what you owe. In the case of both secured debt and unsecured debt, the creditor will report late or non-payment to the credit bureaus so it can be reflected on your credit score. Creditors may also engage in progressively aggressive collection attempts to coax you to pay the debt. If that doesn’t work, the lender could sue you and ask for your wages to be garnished.
Unsecured debt in the form of credit cards may have more restrictive repayment requirements, shorter grace periods and more penalties or fees accompanying late payments. In some cases, a single late payment can raise the interest rate associated with your debt.
Prioritizing Secured Debt and Unsecured Debt
If you’re in a tight financial situation and can’t afford to pay all of your debts, secured debts are typically best to pay first. These payments are often harder to catch up with and you stand to lose essential things, (like your home or transportation) if you don’t pay.