Chances are good you’ll need to borrow money at some point during your life. When you do, it’s important to know what kind of debt you’re taking on: secured debt or unsecured debt.
There are big differences between these two categories of debt, both in terms of the risks as well as the amount of interest you’re likely to pay for borrowing.
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What is the difference between secured and unsecured debt?
The difference between secured and unsecured debt can be summed up in one word: collateral.
When debt is secured, something of value acts as collateral. The lender is almost guaranteed to be repaid because if you don’t send in payments, the lender could take the collateral and re-sell it to recoup the money they loaned out.
If a debt is unsecured, there is no collateral. The only thing guaranteeing you’ll repay the debt is your promise to repay it. If you break that promise, the lender has limited recourse. The lender could go to court, get a judgement against you, and then go back to court to enforce that judgement. But, all of that costs the lender money — and there is no guarantee that you’d even have the cash to pay after all of these steps are taken.
There’s much more risk for the lender when it comes to unsecured debt, and it is this additional risk that accounts for many of the other differences between secured and unsecured debt. Of course, there’s less risk for borrowers who take on unsecured debt because there’s no quick process for their assets to be taken if they don’t pay.
Examples of secured vs. unsecured debt
To tell if debt is secured, consider whether there’s any items of value guaranteeing the loan. For example, some common types of secured debt include:
- Mortgages, which are secured by the home. The house is the collateral and the lender can foreclose and sell it if you don’t pay.
- Car loans, which are secured by the vehicle. The car is the collateral and the lender can repossess it and sell it if you default on the loan.
- Secured credit cards. Usually, when you get a secured card, you’ll have 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’s nothing of value for the lender to take if you default, the loan is unsecured. Common types of unsecured debt include:
- Most credit cards: You can charge anything you want 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 might use the personal loan to buy tangible assets, the lender doesn’t have a security interest in them — which means the lender has no right to just take the items you bought with the borrowed money if you don’t fulfill your payment obligations.
- Medical debts: The care provider can’t take back the healthcare services you received if you don’t pay.
The interest rates differ on secured vs. unsecured debt
One thing you may notice from the list of secured vs. unsecured debts: most of the loans on the list of secured debts tend to have significantly lower interest rates than the loans on the list of unsecured debts. For example, as of September 2018, the national average interest rate on a 30-year conventional mortgage loan is 4.71%. Meanwhile, the average interest rate on a credit card is around 13.64%.
There’s a simple reason why interest costs are so much higher on unsecured debt: the lender’s risk.
The chances of a secured debt not being repaid are much smaller because the lender is able to take and sell the collateral if you fail to fulfill your loan obligations. While there’s still a chance the lender could lose some money — say, if the house or car doesn’t sell for as much as you owe — this risk is minimal because lenders typically require you to put down a down payment. With the down payment, you borrow less than the collateral is worth 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 repaid what’s owed on a secured debt if you file for bankruptcy.
With an unsecured debt, on the other hand, if you filed for bankruptcy, there’s a chance the debt could be discharged and the lender wouldn’t even be legally allowed to collect. Even if you didn’t file for bankruptcy, if you opted not to pay the bill, the lender would face a legal battle to try to recoup the unpaid funds with no guarantee at the end that you’d have money to pay even if they prevailed.
Approval may be easier for secured debts
Because there’s 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 terrible. That’s why many people obtain 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 may be required to put down a larger down payment so the lender is better protected in case you default.
But, you have a better chance of finding someone to give you a secured loan than an unsecured one. That’s why people sometimes take out car title loans — despite the fact that borrowing terms are terrible. They can get approved for them even when other sources of credit aren’t available, since the car acts 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 significantly reduced, borrowers take on a much bigger risk when they agree to a secured loan.
If you put your home or car as collateral and end up not being able to pay the bills, foreclosure or repossession are almost certain. The lender can sell your house or car and keep enough of the proceeds to repay the unpaid debt balance and any legal costs.
If the house or car sells for more than you owe — including fees — you get the difference. If the home or car sells for just enough to repay the lender, you’d get nothing. And, in many cases, if the house or car sells for less than you owe, the lender could pursue a claim against you to try to recoup additional funds.
With unsecured debt, on the other hand, defaulting could ruin your credit and lead to a lawsuit — but many people default without being sued and don’t end up having to repay what they owe.
If you have unsecured debt — like credit card and personal loan debt — and are thinking about taking a second mortgage to pay it, think carefully about whether you want to convert that unsecured debt into secured debt with your home as collateral. If you get into financial trouble, suddenly your home is at grave risk when it wouldn’t have been had you kept the credit cards.
Every borrower needs to know the difference between secured and unsecured debt
Taking on secured debt in certain circumstances makes good sense for borrowers. If you’re trying to build credit and can’t get a conventional card, a secured credit card could be the tool you need to establish a positive payment history and work towards earning a good credit score.
If you want to buy a home or a car, getting a secured loan also makes sense because the lower interest rate makes these big purchases more affordable. Plus, you get tax breaks for mortgage interest you don’t get for other kinds of debt.
But, you should understand the risks before you borrow, and make sure you’re confident you can pay the bills on time so you don’t end up investing a lot of money paying down loans for assets you lose due to a default. Of course, you should never borrow any money — whether a secured or unsecured loan — unless you’re confident you can pay it back.
View more information: https://www.fool.com/the-ascent/banks/articles/whats-the-difference-between-secured-and-unsecured-debt/