When talking about debt, it’s important to understand the two major forms: unsecured debt and secured debt. Knowing what types of debt you owe, and the differences between secured and unsecured debt, is crucial when it comes to personal finance. This article will define each type of debt, discuss the differences, highlight pros and cons and provide ways to manage it in your budget.
What is unsecured debt?
Unsecured debt is borrowed money that has no collateral — something pledged as security for repayment — attached in case the borrower defaults on the loan. If the borrower defaults on the debt, the bank or lender has nothing to take back as repayment for the debt. Interest rates are usually higher with unsecured loans because they are riskier for the lender.
Common forms of unsecured debt include:
- Student loans: A student loan is money given by a financial institution or the federal government to a student to pay for advanced education. A student does not have to put down collateral in order to obtain a student loan.
- Personal loans: Personal loans are another form of unsecured debt. An individual can take out a personal loan for a variety of financial reasons without having to put down collateral — like a home or car — in exchange for the initial loan.
- Credit cards: Credit cards allow people to borrow money from the bank to make any purchase on credit, with the stipulation that you’ll pay the amount back within a certain period of time. If you pay the bank back in full within the appointed amount of time (no less than 21 days), you will not owe any interest or additional payments on the card. If you fail to pay off your debt during the grace period, you will owe interest money in addition to the original amount owed.
As with all things, there are pros and cons to unsecured debt.
Pros of unsecured debt
1. Unsecured debt is less risky for the borrower
Unsecured debt is less risky for the borrower and more risky for the lender. Because lenders do not have any collateral for your unsecured debt, you cannot lose any of your assets if you cannot make a payment. A lender is not able to take back the purchases you charged on your credit card, but there are other consequences to not repaying unsecured debt.
2. Unsecured debt could improve your credit score if paid in full
If borrowers are diligent about paying their monthly payments on time, this can improve their overall credit score. By regularly paying the debt in full, you’re proving that you are reliable, trustworthy and a safe bet for future loans.
3. Unsecured loans can be used at your discretion
Unsecured loans can be used to pay for a variety of items. Though debt like student loans is limited in its uses, borrowers can use personal loans or credit cards to pay for almost anything, including medical bills, home remodels or debt consolidation. These types of unsecured loans offer borrowers flexibility and more choices on how they use the money borrowed.
Cons of unsecured debt
1. Missed payments can negatively impact your credit
While paying an unsecured debt on time can improve your credit score, missing payments can negatively impact your credit. Lenders can report your failure to pay to a credit bureau, which can lower your credit score and make it more difficult to obtain loans in the future.
2. Unsecured debt can be reported to a debt collector
If you’re unable to pay back your unsecured debt, the lender will likely hire a debt collector to press you to pay back your debt. Debt collectors can aggressively hound you to receive payment for your unsecured debt, and failure to pay it back may also result in legal issues where you can be sued.
What is secured debt?
Secured debt is backed with or guaranteed by collateral and assets. Should a borrower default on a secured loan, the lender has the legal right to take said collateral as payback for the debt owed.
Common forms of secured debt are:
- Mortgages: A mortgage is a loan from a bank or a mortgage lender that helps you finance the purchase of a home. Borrowers acquire a mortgage knowing that if they default on their monthly payments, the bank can take the house from them as payment for the debt. The house is the collateral that secures the debt.
- Vehicle loans: Like a mortgage, a loan for a car is a secured form of debt. Vehicle loans are money given to a borrower to put towards a vehicle. Should the borrower not make the required car payment, the lender can repossess the car to satisfy the debt.
- Car title loans: Once you have paid off your vehicle loan in full, you will own the car outright and receive the car title. A car title can then be used as collateral for future loans. The borrower can give the lender the car title as an asset. Should the borrower default on said loan, they would not receive the car title back until the debt was repaid in full.
Pros of secured debt
1. Secured debt usually has lower interest rates
Secured debts are less risky for lenders because the loan is secured by an asset. If you don’t pay up, the lender can take your collateral to earn back the money it lost on their loan to you. Because the loan is a safer bet, banks and lenders usually offer better interest rates. Lower interest rates allow you to pay more to the principle each month, which in turn, allows you to pay off the loan faster.
For example, the average interest rate on a 30-year mortgage is 4.83% (as of Nov. 1 2018), according to Freddie Mac. In comparison, the interest rate on a personal loan can vary anywhere from 4.99% to 29.99%, according to Lending Tree, which owns Magnify Money.
2. Secured loans can be easier to obtain
Secured loans are a relatively safe option for lenders. By securing your loan with collateral, you’re telling the bank that if you default, they can take said collateral as payment.
Because of this, secured loans are often easier for borrowers to obtain. Unsecured loans are often dependent on your credit score, so not everyone can qualify. While credit score does play a role in obtaining any type of loan, secured loans may have less stringent requirements for borrowers to meet.
3. Secured debt allows you to build credit
When you pay your monthly mortgage or vehicle payment on time, you’re showing lenders that you are a reliable borrower. This in turn boosts your credit score and allows you to improve your credit for future loans.
Cons of secured debt
1. Failure to pay secured debts results in loss of assets
Unlike unsecured debt, failure to pay secured debts results in loss of your collateral. Should you miss payments on your mortgage or vehicle, the lender can foreclose on your home or repossess your car.
2. Default on secured loans can damage your credit
While paying your secured debt on time can build your credit and improve your credit score, failure to pay your secured debt can result in major damage to your credit and affect your ability to get a loan in the future. In addition to losing physical assets with a secured loan, you can also damage your credit score, which can have serious financial repercussions.
Which form of debt is better?
All debt — secured and unsecured — should be taken seriously. Mismanaged debt can negatively impact your credit score, affect your ability to get any kind of future loan and wreck your budget and personal finances.
Secured debt is necessary for obtaining a mortgage or a vehicle loan. You’ll often receive a lower interest rate and higher loan amount, but will have larger consequences — like losing your assets — for missing a payment or defaulting on the debt. Unsecured debt requires no up-front collateral, but failure to pay can result in battles with debt collectors and the courts, and can also damage your credit score and financial history.
Whether you’re paying off secured or unsecured debt, it’s important to ensure you’re making your monthly payments and paying them on time. Failure to pay off debt can result in unnecessary interest payments, loss of assets, damage to your credit score, financial stress and serious legal issues.