If you are trying to manage debt or planning to apply for a loan, knowing the details about secured debt vs unsecured debt is critical. It is important whether a debt is secured or unsecured because it can impact your ability to pay it back, as well as the interest rate and terms of repayment.
To put things simply, the main difference between secured and unsecured debt is that secured debt is backed by collateral, while unsecured debt is not.
Collateral is an asset or assets from the borrower which acts as a guarantee to the lender that the debt will be repaid. If the borrower fails to repay the debt, the lender can seize the collateral and use it to recoup their losses.
Interested in learning more about secured debt vs unsecured debt? Read on for a detailed explanation of each type of debt, as well as their key differences.
What Is Secured Debt?
Secured debt is debt that is backed by collateral.
This kind of debt benefits the lender because they can take your assets if you default on the loan. Loans can be secured by a variety of things and assets including but not limited to:
- Real Estate
- Vehicles
- Equipment
- Jewelry
In most cases, a secured debt is secured by the very item you're borrowing the money to purchase. For example, if you're taking out a loan to buy a car, the car would be used as collateral for the loan. The same goes for a home mortgage — the house is the collateral. If you default on secured debt payments, the lender can repossess your assets.
What Is Unsecured Debt?
Unsecured debt is debt that is not backed by collateral.
This kind of debt is money that's borrowed by the individual and is not secured by any assets. Take for example, credit card debt — it's often unsecured. If a borrower defaults on their payments, the lender can't take any of their assets as a form of payment.
Instead, they can only try to collect the debt through other methods, like a wage garnishment or legal action. Another common type of unsecured debt is medical debt.
While unsecured debt doesn't have any collateral associated with it, that doesn't mean it's risk-free for lenders. They still expect to be repaid and will often charge higher interest rates to offset the additional risk they're taking on by lending money to someone without any collateral.
In most cases, lenders typically look at a borrower's creditworthiness and decide whether or not they're a good candidate for unsecured debt based on that. They also look at the borrower's history of borrowing as well as the borrower's income to see if they can comfortably afford the payments.
Secured Debt vs Unsecured Debt
The absence of security in one debt and the presence of it in the other is the primary difference between secured and unsecured debt.
Unsecured debt is not tied to any asset, so if a borrower defaults on their payments, the lender can't take any of their assets as a form of payment. With secured debt, the collateralized asset can be seized if the borrower doesn't make their payments.
Let's go through each debt's pros and cons to better understand how they work.
Advantages of Unsecured Debt
- There's no risk of losing your assets: Since unsecured debt isn't backed by collateral, you don't have to worry about the lender taking your assets if you can't make your payments.
- Flexible loans: Unsecured debt can be made for a wide range of purposes, so you're not limited in how you can use the money you borrow.
- Easier to qualify: The application process can be a lot faster since there's no appraisal process required.
- Available in different forms: Unsecured debt comes in many different forms, like personal loans, credit cards, and lines of credit.
Disadvantages of Unsecured Debt
- It can be more expensive: Interest rates are typically higher with unsecured debt because there's more risk for the lender.
- You may need good credit: Many lenders require borrowers to have good or excellent credit in order to qualify for an unsecured debt loan.
- Delayed/Missed payments can directly impact your credit score: If you miss or make late payments on your unsecured debt, it can directly impact your credit score which can result in you paying higher interest rates in the future and a low credit score on your credit history.
Advantages of Secured Debt
- Easier to get: The collateral acts as a safety net for the lender, so they're more likely to approve your loan. In most cases, a borrower with a lower credit score can still qualify for a secured loan.
- Lower interest rates: Interest rates are typically lower with secured debt because the lender has less risk.
- Tax benefits: On mortgages, borrowers can deduct the interest they paid on their taxes which can lower the amount of money they owe.
Disadvantages of Secured Debt
- You could lose your asset if you can't make payments: The whole point of secured debt is that the lender can take your assets if you don't make your payments. So, if you're not able to make your payments, you could lose your home or your car.
- They are less flexible: This kind of loan is generally tied to the purchase of a specific asset, so you can't use the money for other purposes.
- Might require insurance coverage for the asset: In some cases, the lender may require you to have insurance on the asset that's being used as collateral. For cars, comprehensive insurance policies are typically required. For homes, lender's insurance is typically required.
Types of Unsecured Debt
Here are some of the best examples of unsecured debt:
- Credit cards - Credit cards fall into the category of unsecured debt or loan. It is a type of unsecured loan that allows you to borrow money and pay it off over time. Credit cards generally have low-interest rates and can be used for purchases or cash advances. They are often used as a form of short-term financing when other sources of money are unavailable at the time of purchase or when funds are limited.
- Student loans - Student loans are another common type of unsecured debt that people take out for various reasons during college or graduate school. These loans typically come with better interest rates than traditional bank loans because they're backed by the federal government. In addition to low-interest rates, student loans offer flexible repayment options such as income-based repayment plans (IBRs) that allow borrowers to repay their debt based on their earnings instead of their debt balance.
- Personal loans - Personal loans are just like student loans in that they're unsecured debts that can be used for a variety of purposes. However, personal loans typically have higher interest rates than student loans because they're not backed by the government. Personal loans can be used for things like consolidating debt, paying off high-interest credit card debt, or funding a large purchase.
- Medical debt - Medical debt in general is unsecured, meaning it's not backed by any collateral. This type of debt can be caused by a variety of things such as unexpected medical bills, high deductibles, or copays. Medical debt can be especially difficult to handle because it's often unexpected and can be very expensive. If you're struggling to pay off medical debt, there are a few options available to you such as financial assistance programs, debt settlement, or bankruptcy.
Types of secured Debt
Here are some types of secured debt:
- Mortgages - Mortgages are those big loans people take out to buy a house. The loan is "secured" by the house itself — meaning, if you can't make your payments, the lender can take your house away from you. Mortgages typically have longer repayment terms than other types of debt, such as credit cards or personal loans. This means you'll have a lower monthly payment, but you'll be paying off the debt for a longer period of time. On average, repayment for a mortgage takes 25 years. Some first-time buyers take out 30 to 35 years of home loans.
- Home equity loans - The same as above, a home equity loan is secured by your house. But instead of using the loan to buy a house, people usually use home equity loans to make improvements to their house — such as, adding an addition, fixing up the roof, or repaying other debts.
- Auto loans - Auto loans or car loans are other types of secured debt. The loan is "secured" by the car itself, which means if you can't make your payments, the lender can take your car away from you. Auto loans typically have shorter repayment terms than mortgages or home equity loans. The average auto loan is repaid in five years. And like other types of secured debt, the shorter the repayment term, the higher your monthly payments will be. But, you'll also be debt-free much sooner.
Which Debt Should You Pay First
Whatever loans you may have, secured or unsecured, having a plan on how to pay off debt is important. You’ll generally want to prioritize paying off high-interest debt first because it costs you the most money in the long run. However, there may be other strategies that make more sense for your unique financial situation.
Secured debt is the most obvious debt to pay off first. This is because if you don’t make your payments, the lender can repossess your collateral. This is especially critical if your collateral is your car or your home. You don't want to end up losing your home or having your car repossessed because you couldn't make the payments.
The CFPB, or the Consumer Financial Protection Bureau, offers two methods for repaying your debts:
Snowball Method
This method has you list your debts from smallest to largest, regardless of interest rate. You make the minimum payment on all debts except the smallest one. That means you are going to put as much money as you can towards the smallest debt until it is paid off. Then, you move on to the next debt on your list and treat it the same way. The goal is to pay off each debt one by one until you are debt-free.
Avalanche Method
Referred to as the "highest interest rate method", the Avalanche approach has you list your debts from highest to lowest interest rate. The minimum payments are made on all debts except the one with the highest interest rate. You will put as much money as you can towards the debt with the highest interest until it is paid off and then move on to the next debt on your list.
This is important if you have a debt that has an interest rate that stands out as significantly higher than the others. This way, you are not paying more in interest than you have to and you'll become debt-free from the higher interest debt quicker.
It is important to have a list of your debts so you can see better which debt you need to focus on first.
Final Thoughts
Debt is not an ideal situation to have in your life, but it doesn’t have to be stressful. In many cases, people can find they have too much debt and feel like they are drowning. If this is you, don’t worry, you are not alone.
Creating a plan and taking action to get out of debt is the best thing you can do for yourself. Whether you have secured or unsecured debt, make a plan and focus on paying off your debt one step at a time.
At 121 Financial Credit Union, we help people manage their finances using our free online banking tool. Access your finances with a click by simply logging in to your account. You'll be able to see all of your accounts, including loans and credit cards, in one place.
We also provide home and auto loans, as well as personal loans, to help you pay off debt. If you are in Jacksonville, feel free to contact us and learn how 121 Financial Credit Union can help you work towards becoming debt-free.