Chances are, you’ll need to borrow money at some point in your life. When you do, it’s important to know what kind of debt you are incurring: secured debt or unsecured debt.
There are big differences between these two categories of debt, both in terms of risk and the amount of interest you are likely to pay to borrow.
What is the difference between secured debt and unsecured debt?
The difference between secured and unsecured debt can be summed up in one word: secured.
When debt is secured, something of value serves as collateral. The lender is almost guaranteed to be paid back, because if you don’t send payments, the lender could take the collateral and sell it back to get the money they loaned.
If a debt is unsecured, there is no guarantee. The only thing that guarantees that you will pay off the debt is your promise to pay it off. If you break this promise, the lender has limited recourse. The lender could go to court, get a judgment against you, then go back to court to enforce that judgment. But, all of this costs the lender money – and there is no guarantee that you would even have the money to pay after all of these steps were taken.
There is a lot more risk for the lender when it comes to unsecured debt, and it is this added risk that explains many other differences between secured and unsecured debt. Of course, there is less risk for borrowers who take on unsecured debt because there is no quick process for their assets to be taken if they don’t pay.
Examples of secured and unsecured debt
To find out if the debt is secured, determine if there are any items of value securing the loan. For example, some common types of secured debt include:
- Mortgages, which are secured by the house. The house is collateral and the lender can foreclose and sell it if you don’t pay.
- Auto loans, which are secured by the vehicle. The car is the collateral and the lender can repossess it and sell it if you don’t pay off the loan.
- Secured credit cards. Usually when you get a secured card you will need to deposit an amount of money equal to the credit limit. If you don’t pay the bill, the lender just keeps the money.
If there is nothing of value to the lender in default of payment, the loan is unsecured. Common types of unsecured debt include:
- Most credit card: You can charge anything on your card, and the lender can’t come to your house and take back the items you bought if you don’t pay the bill.
- Most personal loans: Although you can use the personal loan to purchase tangible assets, the lender does not have any collateral on them – meaning the lender is not allowed to just take the items you purchased with borrowed money if you don’t meet your payment obligations.
- Medical debts: The health care provider cannot take back the health services you received if you don’t pay.
Interest rates differ on secured and unsecured debt
One thing you might notice in the secured debt vs. unsecured debt list: Most of the loans on the secured debt list tend to have significantly lower interest rates than the loans on the unsecured debt list. unsecured debts. For example, in September 2018, the national average interest rate on a 30-year conventional mortgage was 4.71%. Meanwhile, the average interest rate on a credit card is around 13.64%.
There’s a simple reason the interest charges are so much higher on unsecured debt: lender risk.
The chances that a secured debt will not be repaid is much lower because the lender is able to accept and sell the collateral if you fail to meet your loan obligations. While there is still a chance that the lender will lose money – say, if the house or car doesn’t sell for as much as you need to – this risk is minimal because lenders usually require you to make a down payment. . With the down payment, you borrow less than the value of the collateral, so a sale should generate enough for full payment of the loan balance.
Because the lender can take the asset, the lender is even likely to be paid back what is owed on secured debt if you file for bankruptcy.
In contrast, with unsecured debt, if you file for bankruptcy, the debt may be discharged and the lender may not even be legally authorized to collect. Even if you did not file for bankruptcy, if you chose not to pay the bill, the lender would face a legal battle to try to recover the unpaid funds without collateral in the end that you would have the money to. pay even if it has prevailed.
Approval May Be Easier For Secured Receivables
Because there are collateral and lenders face minimal risk, many lenders are also more willing to approve borrowers for secured loans than for unsecured loans. For example, you can get a secured credit card even if your credit is bad. This is why many people get these cards to help them rebuild their credit score after financial problems.
If your credit is poor, you may be charged more for secured loans than someone with good credit, or you may need to make a larger down payment so that the lender is better protected in the event of default.
But, you have a better chance of finding someone to give you a secured loan than an unsecured loan. This is why people sometimes take out auto title loans – despite the fact that the borrowing terms are terrible. They can be approved for themselves even when other sources of credit are not available, since the car serves as collateral.
A borrower’s risk is greater with secured debt
While a lender may prefer secured debt because the chances of losing money on the loan are drastically reduced, borrowers take a much greater risk when accepting a secured loan.
If you put your home or car as collateral and can’t pay the bills, foreclosure or repossession is almost certain. The lender can sell your house or car and keep enough of the proceeds to pay off the outstanding debt and legal fees.
If the house or car sells for more than you owe (including costs), you get the difference. If the house or car sells for just enough to pay off the lender, you won’t get anything. And, in many cases, if the house or car sells for less than you owe, the lender could sue you in an attempt to recover additional funds.
In contrast, with unsecured debt, a default could ruin your credit and lead to a lawsuit – but many people default without being sued and don’t end up having to pay back what they owe.
If you have unsecured debt, like credit card debt and personal loans, and are considering taking out a second mortgage to pay them off, think carefully about converting those unsecured debt into secured debt with your home. warranty. If you’re in financial trouble, your home is suddenly threatened when it wouldn’t have been if you had kept credit cards.
Every borrower should know the difference between secured and unsecured debt
Taking secured debt under certain circumstances makes sense for borrowers. If you’re trying to build credit and can’t get a conventional card, a secured credit card might be the tool you need to build a positive payment history and work towards achieving a good credit score.
If you want to buy a house or a car, get a secured loan also makes sense because the lower interest rate makes those big purchases more affordable. Plus, you get tax breaks for mortgage interest that you don’t get for other types of debt.
But you need to understand the risks before you borrow and make sure that you can pay the bills on time so that you don’t invest a lot of money to pay off loans for assets that you lose due to default. Of course, you should never borrow money – whether it’s a secured loan or not – unless you are sure you can repay it.