You're probably familiar with the concept of debt, but did you know that there are actually two common types of debt?
Secured and unsecured debt are two main categories that debt can fall under. Secured debt is backed by collateral while unsecured debt is not. In this article, we'll dive into the differences between these two types of debt and how they can affect your finances.
Let's get started!
What Are Secured Debts?
If you have a mortgage or car loan, you're no stranger to secured debts. Secured debts are basically loans that are supported by a form of collateral – like a car or a house – to back them up.
Other than providing a collateral to back up your loan, lenders might also check your credit and assess your financial situation to determine if you're eligible for a secured loan.
Common examples of secured loans include:
- Mortgages
- Auto loans
- Home equity loans (Equity lines)
- Secured credit cards
And other kinds of collateralized debt.
If you're ever unable to pay for the loan, your lender will be able to take the collateral that you've put up as compensation for the unpaid loan.
The collateral you put up is basically a way for your lender to protect themselves and make sure they get their money back incase you're unable to pay back your debt.
Benefits of Secured Debts:
There are numerous benefits to taking secured loans.
The rates on secured debts are often times lower compared to unsecured debts. This is because the lender has assurance they'll be able to make their money back if a borrower can't pay back their loan, allowing them to offer a lower interest rate in exchange for that security.
This same assurance let's lenders also give borrowers more flexible payment options and longer repayment terms if they're ever i a pinch.
The processing time for secured debts are also generally faster compared to unsecured debts as lenders are more willing to loan the money even if a borrower doesn't have an excellent credit score. The time cut back on a robust background check on a borrower generally leads to faster processing time.
What Are Unsecured Debts?
Unsecured debts, on the other hand, are loans that don't require any collateral to back them up. If you've ever used traditional credit cards or gotten lines of credit, you'll be familiar with unsecured loans.
To be eligible for an unsecured loan, lenders will look at your credit score, income, employment status and your other financial information. They'll also check your debt-to-income ratio and credit histories to make sure you can afford the monthly payments of your debt based on your current income.
Common examples of unsecured debts include:
- Credit Card Debt (Unsecured Credit Cards)
- Medical Bills
- Student Loans
- Personal Loans
If a borrower defaults on their loan, lenders will normally reach out to the borrower to ask them for the money. If the borrower persists in delaying their payments, a lender will need to file a lawsuit or perform wage garnishment to get their money back if a borrower is unable to pay them back for the loan.
Benefits of Unsecured Debts:
Not everyone has the option to put up collateral when they're in financial distress. This is where unsecured loans can help a person out. Unsecured loans allow people to take out loans in times of need without having to put up collateral
If you are looking to pay off your loan quickly after borrowing, unsecured loans are a good option as they have shorter repayment terms compared to secured debts.
Unsecured debts also often come with credit limits when it comes to personal loans and credit cards. This can help borrowers manage their spending and ensure they don't take on more debt than they can afford.
Unsecured debt can also be used for a variety of purposes, making it a flexible payment option if you're ever in need. It can even be used for consolidating your existing debt.
Key Differences Between Secured & Unsecured Debts
- Collateral: Secured debts require collateral while unsecured debts do not.
- Processing Time: Secured debts generally require less time to process compared to unsecured debts as unsecured debts may require more rigorous background checks to ensure you are able to pay off your loan.
- Approval Rate: Having collateral to back up your loan in secured debts lowers a lender's risk, making it easier for you to get your loan approved. For unsecured debts, only people with good credit scores and strong financial standing get their loan approved easily.
- Credit Score Requirement: To get a secured loan, borrowers will generally need to have a credit score of 650 or higher. For an unsecured loan, borrowers will need to have a credit score of 700 or above.
- Rates: Secured debts have lower rates compared to unsecured debts due to the the lower risk to lenders.
Ways To Pay off Secured & Unsecured Debts
Two efficient methods you can adopt to pay off your secured and unsecured debts include the snowball method, the avalanche method and debt consolidation.
Snowball Method
The snowball method involves paying off your smallest debt first and then using the money you saved to pay off your next smallest debt. This method can help you build momentum and motivation as you pay off each debt one by one.
Guide: The Debt Snowball Method: How It Works and Why It's Effective
Avalanche Method
Another great way to pay off debt is by adopting the Avalanche method.
The avalanche method is a way to repay your debts that involves paying the debt with the highest interest rates first while making the minimum payments on your other debts. The goal of the avalanche method is to save money on interest charges by paying off the most expensive debts first.
Guide: avelanche-method (INSERT HERE)
Debt Consolidation
Tired of paying off multiple debts every month and juggling all your loans? Debt consolidation may be just the method for you! Debt consolidation is a way to combine multiple debts into one single debt. It can be a helpful tool for people who have multiple debts and are struggling to keep track of them or make their monthly payments. On the plus side, with debt consolidation, you can also possibly get lower interest rates.
Which Debt Should You Prioritize Paying Off?
It can be tricky to decide which debt you should pay off first if you're in a financial pinch and the answer to this question completely depends on your financial situation. If you're deciding which loan payments you should prioritize, here are some things to consider.
1. Interest rates: Consider the interest rate of each debt and prioritize paying off the one with the highest rate first. Unsecured debts have higher interest rates and late payment charges compared to secured debts. Prioritizing your unsecured debts will help to alleviate these additional charges from snowballing.
2. Secured vs unsecured: Secured debts have lower rates compared to unsecured debts due to the lower risk to lenders, so it may be beneficial to pay those off first. With secured loans, your asset will also be at risk when you miss your payments. If you are far behind on your payments, prioritizing these loans will ensure that your assets are not seized by your lender.
3. Late fees: When it comes to both secured and unsecured debt, make sure to make all of your minimum payments on time each month in order to avoid further late fees and other penalties from piling up.
4. Consolidation: Look into consolidating your debts in order to reduce interest rates and simplify repayment.
5. Financing Terms: Financing terms for secured loans CAN be more flexible compared to unsecured loans, depending on your lender. If you're in a pinch, it wouldn't hurt to reach out to your lender to discuss an alternative payment schedule or debt settlement options.
6. Financial situation: Ultimately, the best way to decide which debt to prioritize is to look at your overall financial situation and determine which debt will provide the most benefit in the long run.
Conclusion
Secured and unsecured loans are two very different types of debt. We hope that by understanding their differences, you're able to make a more informed decision on which loan will best suit your financial needs. Ultimately, it is important to assess your financial situation and determine which debt will provide the most benefit to you in the long run.
Aidan has been writing about personal finance for over 6 years. Prior to this, he worked as a Corporate Finance Analyst where he specialized in Due Diligence, Company Valuations and more. He is a CFA charterholder.
