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Secured and unsecured debts have many similarities, but one major difference is whether collateral is required. As the name implies, secured debt requires collateral to back the loan, but this isn’t the case for unsecured debt.
The type of debt you select could also affect the interest rate and loan terms you’ll receive. Plus, you’ll find that the eligibility criteria for the two are different. So, it’s worth understanding how both secured and unsecured debt work before applying for any financing to ensure you’re making an educated decision that will benefit you financially over time.
Unsecured debt is a common form of debt that’s not backed by collateral. If you default on those debt payments, the lender has no property to seize to recoup its losses. Instead, penalties will come from credit score decreases and the debt being sent to creditors.
- Credit cards: These debt products can be used when you need more money than you have to cover a financial emergency, like an unexpected medical bill or a last-minute flight for a funeral.
- Medical loans: A personal loan used specifically to cover the cost of medical treatments and procedures.
- Personal loans: You can generally use the loan proceeds however you see fit. However, some lenders disallow the use of funds for business or higher education expenses.
- Student loans: If you’re attending a college or university with unmet financial needs, you can take out a student loan to help fill the void.
Many unsecured debt products have a seamless application process and fast funding times. Plus, these loans are often attractive since they don’t require collateral to get approved. Still, there are downsides to consider. These debt products are often subject to higher interest rates since they pose more risk to the lender. Furthermore, the lender or creditor will likely require you to have good or excellent credit to qualify for competitive financing.
Other forms of unsecured debt can include utility bills, lawyer’s fees or taxes, the costs of which can easily negatively affect your credit.
Secured debt is debt that is backed by property, like a car or a house. Should you default on the loan or debt repayment, the creditor can take the collateral instead of opening a debt collection on your record or suing you for payments.
Consensual loans are the most common type of secured debt, wherein you as a borrower agree to put up your property as collateral. But there are many types of nonconsensual loans, too. Nonconsensual debts include a money judgment that a creditor files against you or a tax lien placed against your property because you did not pay your federal, state or local taxes.
- Auto loans: These loan products are used solely to finance new and used automobile purchases.
- Home equity lines of credit (HELOCs): You can pull equity from your home with a HELOC. At closing, you’ll get access to a pool of cash that you can withdraw from during what’s referred to as the draw period, which is typically 10 years. The interest rate on HELOCs is usually variable, although some lenders offer fixed-rate products.
- Home equity loans: Like HELOCs, home equity loans let you convert a portion of your home’s equity into cash. You’ll receive the funds in a lump sum, though, and the interest rate is generally fixed.
- Mortgages: You can take out a mortgage to purchase a new home.
- Secured credit cards: They work like traditional credit cards but require a deposit, usually equivalent to the credit limit, to get approved. If you fall behind on the minimum monthly payments, the credit card issuer can take the amount they’re owed from the security deposit.
With secured debt, you often benefit from better interest rates because if you stop making payments, the lender can seize the property and sell it to regain its losses. Creditors are more flexible with terms because the loan is guaranteed by the collateral and poses less risk to the bank.
Still, you risk losing your asset if you experience financial hardship and fall behind on the loan payments.
Unsecured debt vs. secured debt
While there are similarities between unsecured debt and secured debt, there are also differences you should also be aware of. The most obvious variance is the collateral requirement, but you’ll also find that financing terms and the credit score criteria are also different for the two forms of debt.
While secured debt uses property as collateral to support the loan, unsecured debt has no collateral attached to it. So, you won’t have to worry about putting your asset at risk if you choose the latter.
The interest rates on secured debt products tend to be lower. You may also qualify for a higher loan limit and extended repayment term.
To illustrate, home loan APRs hover between 3 percent and 4 percent with repayment terms of up to 30 years. Because this is a secured debt backed by the house as collateral, borrowers with good credit histories enjoy better rates and terms.
On the other hand, unsecured debt — like credit cards and personal loans — are generally associated with higher interest rates and lower terms. Especially for borrowers who have a limited credit history or bad credit, these rates and terms can be even more restricting.
Credit score criteria
Secured debt can be a better option for people with poor credit history or those with no credit history. It’s also a fantastic tool if you have experienced financial hardship and are looking for ways to rebuild your credit.
Responsible use of a secured loan can improve your credit score so you’re eligible for favorable unsecured loans in the future. Furthermore, some secured credit cards offer additional benefits like free identity theft and credit monitoring.
If you have a low credit score or are just beginning to build your credit, many banks will offer you a secured credit card with varying interest rates. The card is deposit-based; you pay the bank an amount that is then placed onto the credit card. You use the card and make payments with interest as usual; if you default on your payments, the bank uses your deposit to settle the debt. This affects your credit score because banks will report late or missed payments to credit bureaus.
However, lower minimum credit scores typically aren’t permissible when applying for unsecured debt products. Lenders have no recourse if you default on the financing agreement by falling behind on payments. Consequently, they want reassurance that you have responsibly managed debt obligations in the past, and there’s a high likelihood of you doing the same if they approve you for financing.
But there’s an exception to the rule — some lenders feature subprime debt products that cater to consumers with lower credit scores that can’t get approved elsewhere. They may seem like a convenient option to meet your financing needs. However, they often come with steep interest rates, fees and other unfavorable loan terms, making these debt products a costly option.
If you believe you are fiscally responsible enough for an unsecured credit card or small personal loan, they can also be used to rebuild your credit. Be sure to only borrow what you can comfortably afford to repay.
Which type of debt you should prioritize paying off first
When paying off debt, a good rule of thumb is to prioritize paying off debts and loans by the interest rate.
Look at secured versus unsecured debt and start with the loans with the highest interest rate first to save yourself the extra money in accumulating interest. The added benefit of a lower credit utilization ratio will help your credit score increase that much faster. This is known as the avalanche method; as you pay off the debts with the high interest rates, you make more room in your budget to pay off the lower-interest debts. Soon, you’re debt-free and ready to start over with a clean slate.
Sometimes, bankruptcy is necessary to resolve your unsecured debt. This erases your legal responsibility to repay your debt, but it will severely impact your credit score and your chances of getting loans soon.
Paying off secured debt should be a top priority because of the risk to your property. Not only can the government seize your property, but you could still be responsible for additional debts should the repossession fail to cover the full amount of your debt.
Unsecured debt doesn’t come with any strings attached, but it may not be an option for you. You may have to settle for a secured debt product if you’ve had a series of financial missteps and your score is low or you’re new to credit. Both can get you access to the financing you need, but unsecured debt products often come with more stringent qualification criteria and higher interest rates.
Before shopping for a loan or credit card, whether secured or unsecured, check your credit rating to see where you stand. Also, research lenders and consider getting prequalified to see what options may be available to you. These actions will clarify which debt products are best for your financial situation or if it’s best to hold off on and work on your credit health until your FICO score improves.