Debt can be an important tool, whether you’re using it to make large purchases, pay for unexpected expenses, consolidate existing balances or even invest in the future. To understand what type of debt is best for you and your situation, though, it’s important to understand the difference between secured debt and unsecured debt, and how each can be managed over time.
What is unsecured debt?
Unsecured debt is a form of borrowing that is not secured by a specific material asset. Since this type of debt doesn’t require an asset as collateral, there’s nothing specific the lender will take from you if you default on the debt. This includes things like personal loans, student loans and credit cards. (Note that federal student loans are a unique type of debt. They are unsecured, but they do not require the same type of credit review as other loans.)
Without a collateral asset, unsecured debt is considered more risky for lenders. For this reason, it may come with higher interest rates, higher credit score requirements and lower borrowing limits than secured debt.
With that said, unsecured debt can be less risky for borrowers. While you should always plan to pay back your debt as agreed, lenders don’t have a specific asset they can seize if you fail to repay an unsecured loan. That doesn’t mean unsecured loans are without risk, of course. If you miss payments or end up defaulting on these debts, it can still wreck your credit and, in the worst cases, creditors can take legal action against you.
What is secured debt?
Secured debt is a form of borrowing where a collateral asset is used to secure the debt. This category commonly includes loans intended for large, specific purchases, like buying a house or car. Since these loans pose less risk for lenders, they tend to have less strict eligibility criteria, lower interest rates and higher borrowing limits on average.
If the borrower defaults on this type of loan, the lender can assume ownership or control of that asset and use it to recoup lost funds. (This is called foreclosure or repossession, depending on the loan type.)
Whether it’s your home, car or even savings account that’s used as collateral, the fact that the lender can seize the asset if you don’t repay is what distinguishes this type of debt. But it’s not the only risk for borrowers. Defaulting on a secured loan will still damage your credit, leaving you both without the property and in a worse position financially.
Examples of each type of debt
Examples of Unsecured Debt
The better your credit history and score, the more likely you are to get approved for unsecured credit products. If you have a limited credit history or even poor credit, you may be forced to opt for secured credit cards or loans secured with a collateral asset until you demonstrate to lenders that you’re not a risky borrower.
Why it matters if your debt is secured or unsecured
When it comes to repayment, the type of loan you have dictates your options to manage the debt. With secured debt, such as an auto loan or home mortgage, you have the option of refinancing over time. Refinancing could help you lower your interest rate, reduce your monthly payments, pull equity out of the asset in the form of cash, remove a co-borrower and more. Since this debt is secured by a material asset, there’s typically no shortage of lenders that may be willing to refinance the debt. You can also refinance some kinds of unsecured debt, like a personal loan or private student loan. This can be a smart move if your finances have improved since you took the loan out and you can now qualify for better terms.
With unsecured debt, debt consolidation is a common strategy used to get debt free faster. With this method, you take out a new loan that can then be used to pay off one or more existing debts. While you can consolidate some secured debts, the move is commonly used for unsecured debt.
If you’re struggling to make payments, debt relief is an option for unsecured debt — but not for secured debts. With debt relief, you can work with a company to create a debt repayment plan, reduce your interest rates or, in some cases, settle your debts for less than you owe.
The bottom line
Both secured and unsecured debt can be smart options, depending on whether you’re looking to make a big purchase, consolidate existing credit card debt or build your credit score with a credit card. Secured debt may be the better option if you have a limited credit history or are making a very large purchase, but comes with risks since the debt is secured by collateral. Unsecured debt is more flexible and doesn’t risk your assets, but may have higher interest rates and stricter requirements for approval.
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