Understand the difference between secured debt and unsecured debt to make informed decisions
September 24, 2021 – By Rebecca Lake
Borrowing money – whether it’s using a credit card or taking out a personal loan – means creating debt that you have to repay, usually with interest.
But whether its an unsecured debt or secured debt can affect how you decide to prioritize them. Here’s how to tell the difference between secured and unsecured debt and why that matters.
What is secured debt?
In simple terms, secured debts are loans or lines of credit that are backed by some type of collateral.
“Secured debt has something to back it up besides just your name and credit history,” says Dawn-Marie Joseph, founder of Estate Planning & Preservation in Williamston, Michigan.
This collateral will be a physical asset that’s of equal value to what you’re borrowing. The type of asset used for collateral depends largely on what kind of loan you’re getting.
Secured credit and debt can include:
- Mortgages
- Car loans
- Home equity loans or lines of credit
- Secured credit cards
- Secured business loans
“If you don’t make your payments, lenders can seize an asset that serves as collateral,” says Katie Ross, education and development manager for American Consumer Credit Counseling.
For example, lenders make home loans on the assumption that the buyer is going to repay what’s owed with interest. If a homeowner defaults on their mortgage, the lender needs a way to offset potential losses. So they can seize the home and auction it off through a foreclosure proceeding to make up for what the homeowner didn’t pay.
“Secured debt is more risky for the borrower because you risk losing an asset if you don’t make your payments,” says Connor Brown, personal finance expert and founder of After School Finance.
That can be costly, depending on what you pledge as security for a loan or line of credit. In the case of a secured credit card, for instance, the credit card company could keep your cash deposit if you stop making payments. Not to mention, you’re looking at potential credit score damage if late or missed payments are reported to the credit bureaus.
Secured debts have an upside, however, depending on what you’re borrowing.
“Secured debt generally has a lower interest rate, because the lender has a source of collateral if you don’t make your payments,” says Brown. “Mortgages, home equity loans and car loans usually have low rates because they’re backed by collateral with reasonably predictive values.”
In other words, if you’re using a vehicle or home as collateral, the lender can make an accurate guess about what their value will be over time. Depending on your credit history, that could translate to lower interest rates and lower monthly payments for you.
What is unsecured debt?
Unsecured debts aren’t backed by collateral, so there are no assets to seize. There’s still a promise to pay on your part, but you don’t have to put your car, home or another asset on the line to get a loan or line of credit.
Unsecured debts can include:
- Most credit cards
- Personal loans
- Lines of credit
- Federal student loans
- Private student loans
- Peer to peer loans
- Medical debts
- Small business loans
If you default on any of these types of unsecured debt, you won’t risk losing any collateral. But there can be other consequences, Ross says, including being subject to debt collection efforts, being sued in civil court and having your wages or bank accounts garnished.
You might run into those things if you default on an unsecured credit card debt or line of credit, personal loan, private student loans or medical bills. With defaulted federal student loans, the government can also offset your tax refund to help pay back what you owe.
Secured debt vs. unsecured debt: Which is better?
If you’re wondering whether it’s preferable to owe secured versus unsecured debt, the answer isn’t so clear-cut.
“Secured debt is used for many different reasons and isn’t necessarily bad,” says Joseph.
For example, a secured loan is a necessity if you’re getting a mortgage to buy a home. And Joseph notes that in some instances, secured credit cards, loans or lines of credit can be used to repair poor credit scores.
Likewise, certain unsecured debts such as federal student loans are typically seen as “good” debt because they’re used to make an investment in your education. Meanwhile, credit card debt – with its high interest rate – is generally not considered beneficial.
What makes one debt “better” than another may not hinge on whether it’s secured or unsecured as much as things such as:
- Interest rates and fees
- Annual percentage rate
- What it’s being used for
- Whether it positively or negatively impacts you financially
And in the end, what really matters most could be how you handle each type of debt you owe.
“Regardless of the type of debt, if you don’t make your payments, your credit score will be adversely impacted,” says Brown.
For FICO credit scoring, the longer an account goes late or unpaid the worse the impact on your score becomes. And negative information, such as late payments, missed payments, collection accounts and charge-offs, can remain on your credit report for up to seven years.
Managing secured debts vs. unsecured debts
If you have multiple debts, it’s helpful to have a plan for paying them off. The best decision for you might depend on the type of loan and interest rate. Your financial situation could also play into your decision.
If you’re in a tight spot financially, you may want to first pay the debts that have an asset attached to them, such as your mortgage or auto loan. Keeping current on those payments can help you avoid losing your home or car.
Missing payments on unsecured debts could hurt your credit, but there’s no immediate risk of losing any assets. If you’re concerned about staying on top of your debt, remember that your lenders and issuers may have options to help.
For example, you may be able to get a temporary forbearance on mortgage payments, put your federal student loans into deferment or forbearance or apply for a hardship program with your credit card company. These can all be useful in managing secured and unsecured debts while keeping your credit intact as much as possible.
And even if your finances are on solid ground, think carefully about adding to your debt load.
“Do your research before opening up new credit cards, getting a new car loan, taking out student loans, et cetera,” says Ross. “Understand the terms of your loan and what the interest rate is to make sure you can actually afford the payments.”
Bottom line
A simple way to tell the difference between secured debt and unsecured debt is to look at what’s backing it. If a valuable asset is tied to the debt, it’s secured, whereas if the debt is only backed by your name and credit score, then it’s unsecured. And understanding how to prioritize secured debt versus unsecured debt helps you make more informed financial decisions. Always remember that defaulting on secured debt could mean you lose the asset backing it, but defaulting on unsecured debt could mean a devastating hit to your credit score.
