Not all debt is the same! There are two main types of consumer debt: unsecured and secured. The type of debt can affect what happens in the case of default, bankruptcy, debt negotiation, and much more. Consumers who want to practice smart debt management should understand the type of debts they have and the ramifications of a debt being either secured or unsecured.
Knowing the difference between the two can also help you prioritize your debt payments. It's not uncommon for people to ask about the difference between the two and how they may affect a person's credit score and credit history.
Secured debt is debt that is backed by some type of collateral such as an asset or revenue from the borrower. You typically encounter secured debt when you purchase a large ticket item such as a house or a vehicle. Mortgages and car loans are two examples of secured debts. If you fail to pay back the loan as agreed, the lender can foreclose on the home or repossess the vehicle for non-payment. Because there are assets, the lender can use those assets to recoup their loss in the event of a loan default. Interest rates are generally lower on secured loans.
With a secured loan, a lender makes a loan in exchange for an interest in some type of asset that is held as collateral. If the borrower defaults on a secured loan, the lender has the right to repossess or foreclose to recover from their loss.
The most common type of secured loan is a mortgage, which involves a lender placing a lien on the property until the mortgage is fully repaid. If the borrower defaults, the lender can seize the home and sell it to recover the money. Car loans are another common form of secured debt.
With most secured loans, lenders require that the asset is properly insured and/or maintained to preserve the asset's value. In the case of a car loan, this usually means collision, comprehensive, and liability insurance coverage until the loan is paid in full. With a home loan, a lender may require homeowner's insurance in addition to property taxes being paid on time. A borrower will not fully own an asset attached to a secured loan until the debt is paid in full.
Secured loans are typically easier to qualify for than unsecured loans. This is because the lender has the assurance that they will recover all or most of the loan amount if the borrower defaults. Borrowers with poor credit and those who are rebuilding their credit are more likely to be considered for a secured loan than an unsecured loan.
Unsecured debt is debt that is not guaranteed or "backed" by any type of collateral. Essentially this means that if you default on an unsecured debt there is nothing that the creditor can take back to recover their costs for non-payment of the loan. Interest rates tend to be higher on unsecured debt because there is no collateral for the creditor to seize if you default. Credit cards fall into the category of unsecured debt. A credit card company cannot seize any of your possessions if you do not pay off the balance. Creditors attempting to collect on a delinquent unsecured debt typically turn the account over to a collection agency or perhaps they try to issue a lawsuit against the debtor.
Unsecured debts require no collateral to secure a loan. This type of debt is issued based on the consumer's credit rating, ability to repay, and the promise to repay. If a consumer defaults on an unsecured loan, the lender has the right to sue, but this is costly and most lenders will not do so except in the case of significant debt. Most creditors will begin by hiring a debt collector to attempt to collect on a defaulted unsecured loan. Delinquent accounts will also be reported to the 3 major credit bureaus.
Secured loan lenders can take these same steps in case of default, but unsecured creditors cannot pursue any assets directly. Unsecured loans usually have higher interest rates than secured loans because there is no collateral. There are many types of unsecured debts, including credit card debt, medical debt, payday loans, and some retail installment contracts.
Both types of debt will show up on your credit report. A small portion of your credit score (about 10%) is based on the types of debt you carry and whether or not you have a "healthy" mix of credit types. The score takes into account if you have a mix of revolving unsecured credit (credit cards) and secured installment loans (mortgage).
Revolving credit is often the types of loans issued with unsecured debt. Your payment amount can vary, or revolve, based on your account balance and interest rate. Installment loans are typically issued with secured debt. For example, if you take out a vehicle loan, you are given a set schedule of payments to make. Your payment and interest rate generally remain the same each month until the loan is paid in full.
Consumers who have a mix of secured and unsecured debts should prioritize which debts must be paid first if their income is tight. In most cases, it's best to ensure that the secured loans are paid first as these payments tend to be higher and are usually harder to catch up on. Defaulting on a secured loan can also risk losing an essential asset like a home or a vehicle.
Unsecured loans may get a bigger priority for consumers concerned with debt management and saving money. Unsecured debt usually has higher interest rates than secured loans which make them more expensive to carry for a long period of time. Devoting more money each month to paying down unsecured balances can result in significant interest savings.
It's possible for debt to begin as unsecured and then get converted to secured debt and vice versa. There may be advantages for consumers to convert their debt from one form to another, such as consolidating multiple accounts into one monthly payment or securing a lower interest rate.
The most common way to convert unsecured debts into a secured loan is debt consolidation using a home equity loan or home equity line of credit (HELOC). In this case, a consumer can consolidate medical debt and/or credit card debt into a single debt that's secured by the borrower's home. This decision is not without risk: if the borrower defaults, they are risking their home for a debt that would otherwise have been unsecured.
Debt can also begin as a secured loan and turn into an unsecured loan. The most common example of this conversion is when a borrower takes out an unsecured personal loan to pay off a secured car loan. This can result in a lower monthly payment and better interest rate. More importantly, the consumer's vehicle is no longer at risk if the borrower defaults on the loan.
With all types of debt, there are often steep penalties and/or repercussions for not paying as agreed. If you're having trouble managing your unsecured debt payments, you should contact Advantage Credit Counseling Service and talk with a certified credit counselor for free.
It's possible to get your debt under control, and the sooner you start, the sooner you can get on the path towards financial freedom! We've been assisting consumers with their debt issues since 1968 and we can help you too!
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There are two types of debt: unsecured and secured. The type of debt can affect what happens in the case of default, bankruptcy, debt negotiation, and much more.