Whenever you borrow money, you’re creating debt – an obligation to repay back the amount you’ve borrowed, There are two basic types of debt: secured and unsecured. When you’re making borrowing decisions, it’s important to know which type of debt you’re taking on. This helps you know the amount of risk you’re taking on and the potential consequences of not paying back your debt.
Secured Debt vs. Unsecured Debt
Secured debt is a type of debt that is “secured” with collateral. If you default on your payments, the lender can take possession of the collateral as repayment for the debt. Secured credit cards are also a type of secured debt since you’re required to make a security deposit against the credit limit to be approved for the credit card.
You don’t own the collateral tied to the secured debt until you completely repay the loan. With secured credit cards, your security deposit is held until you pay off the balance and close the credit card account.
Here are a few common types of secured debt:
● mortgages, second mortgages, home equity loans
● auto loans
● title loans
● secured credit cards
Secured loans usually have a fixed interest rate, fixed repayment period, and a fixed monthly payment. Predictable monthly payments are easier to budget for. Secured loans are also closed-end meaning you can only borrow the money once.
Unsecured debt is not backed by any type of security or collateral. If you default on your debt obligation, the lender does not have the right to automatically seize any of your property as repayment for your debt unless they sue you and get a court order.
These are a few common types of unsecured debt:
● credit cards
● lines of credit
● student loans
● personal loans
● medical bills
● payday loans
● utility bills
Unsecured debts can have a variable interest rate that changes based on an underlying index rate (often the Prime Rate). This means the monthly minimum payment and repayment period can vary, particularly with revolving debts like credit cards and lines of credit.
Qualifying for Debts
Before lenders allow you to borrow money, they want to be reasonably sure you’ll repay the debt. They’ll check your credit history, your income, your employment, and your current debts to determine whether to approve your application and the terms of the debt.
The larger the debt you’re applying for, the better your finances will need to be to be approved. Larger loans require good credit, higher income, and sometimes even a down payment. Making a down payment on secured debt can be a good idea because you have more equity in the asset sooner and you’re closer to fully owning the asset.
Risks of Secured and Unsecured Debts
There’s always a certain amount of risk involved in the business of lending and borrowing money. That risk is typically represented in the interest rate charged on the debt. The riskier the debt, the higher the interest rate. There’s risk for borrowers, too. If you’re unable to pay what you’ve borrowed, your credit and any assets tied to the debt are at risk.
Secured debt is less risky for lenders beause they’re able to recoup some of the losses from unpaid debts by selling the collateral tied to the debt. Most borrowers will keep up the payments on secured debts, like a mortgage for example, because there’s something to lose by falling behind on your payments.
You’ll find that secured debt – like mortgages – carries lower interest rates than unsecured debt. Even though a lender can sell the asset tied to the debt, it doesn’t mean you’re completely off the hook for unpaid debts. Sometimes the proceeds from the sale of the asset aren’t enough to cover the outstanding loan balance. In that case, you’ll be on the hook for the remainder of the debt.
Unsecured debt is riskier for creditors because there is no collateral for them to collect if the borrower defaults on the payment. Creditors have to take extensive collection action, including filing a lawsuit when borrowers fail to repay unsecured debts.
Because of the increased risk, unsecured debt often carries a higher interest rate. This makes unsecured debt more expensive for consumers.
How Secured and Unsecured Debts Affect Your Credit
Your credit is influenced by how you pay your debts. The amount of debt you have and the timeliness of your payments are the two most important factors in determining your credit score – the three-digit number that indicates whether you have good or bad credit.
Both secured and unsecured debts are listed on your credit report and your account information is updated about each month. The debt isn’t directly reported in a way that indicates it’s a secured debt. However, it can be reasonably assumed whether the debt is secured or unsecured by the nature of the debt. For example, a mortgage loan will always be a secured debt.
Paying on time is important with both secured and unsecured debts since late payments on debts hurt your credit score. Your credit score isn’t the only thing you have to worry about if you’re late on payments with secured debt. You risk losing the asset tied to the debt in addition to damaging your credit score.
Defaulting on secured debts can prevent you from borrowing money in the future. With mortgages, there’s usually a waiting period before you can get another mortgage after a foreclosure.
Neither type of debt benefits your credit more than the other. That said, having experience with multiple types of debt can improve your credit score since “mix of credit” is 10% of your credit score. So, if you have a mortgage, car loan, and credit card, your credit score may be better than if you only had a car loan and a credit card. A positive experience with a mortgage loan shows that you can responsibly handle various types of debt.
While having a mix of credit can improve your credit score, it’s generally not a good idea to take on more debt simply for the sake of having a good credit score. Apply for debts as you need to and your credit score will improve naturally.
Handing Your Debts During Financial Difficulty
Between credit cards, student loans, mortgages, and auto loans, most consumers hold a mix of both secured and unsecured debts. Understanding the types of debt you have can help you prioritize payments if you’re having money problems.
Since missing payments on your secured debt can leave you homeless and without transportation, it’s typically best to prioritize your mortgage and auto loan payments. While they’re the toughest to pay if you’re experiencing financial strain, these payments are higher and harder to catch up on if you fall behind.
Depending on the state where you reside and the terms of your loan agreement, some lenders can begin foreclosure or repossesion proceedings as early as your first missed payment. If you miss a payment on an unsecured debt, however, you’ll be hit with a late fee and phone calls from your creditors. You don’t have to worry about losing anything – except your credit standing and purchasing privileges – if you get behind on unsecured debt.
Getting caught up on your payments may not be as difficult as you think. Make a list of your debts and the monthly payment for each. If you’re behind on any debts, list the past due amount needed to catch up on your payments. Then, use your monthly budget to see how you can afford to get caught up again. Contact your creditors to discuss your payment options so you can see if there’s any flexibility in catching up on your payments.
Secured Debts, Unsecured Debts, and Bankruptcy
If you’re over your head with debt and you haven’t been able to work out an arrangement with your creditors, bankruptcy may be an option to eliminate your debt. Your credit will be affected by filing bankruptcy, but you can work to rebuild your credit score after you’ve completed bankruptcy and your debts are discharged.
Secured debt and unsecured debts are treated differently in bankruptcy. If you want to keep your assets – your home or car – you’ll have be strategic with the type of bankruptcy you file.
With Chapter 7 bankruptcy, any assets you own are liquidated, or sold, and the proceeds are used to pay off your debts. Your home and car may be exempt up to a certain amount depending on which state you flie bankruptcy. Chapter 7 bankruptcy can be used to eliminate secured debts, but you will have to give up the assets tied to those debts. You won’t be able to have the debt erased in bankruptcy and keep your property too.
With Chapter 13 bankruptcy, your assets are not liquidated but you will be entered onto a repayment plan to repay a portion of the debts you owe. After you’ve completed your repayment plan, the remainder of your debts are discharged. This is the type of bankruptcy you should file if you want to keep your home or car.
It’s always best to seek advice from a bankruptcy attorney to learn the options available based on your finances and your state.