Debt can be an important tool, whether you use it to make large purchases, pay for unexpected expenses, consolidate existing balances, or even invest for the future. However, to understand what type of debt is best for you and your situation, it is important to understand the difference between secured debt and unsecured debt, as well as how each can be managed over time.
What is unsecured debt?
Unsecured debt is a form of borrowing that is not backed by a specific tangible asset. Because this type of debt does not require an asset as collateral, the lender will not take anything specific from you if you fail to pay the debt. This includes things like personal loans, student loans, and credit cards. (Note that federal student loans are a unique type of debt. They are unsecured but do not require the same credit checks as other loans.)
Without a collateral asset, unsecured debt is considered riskier to lenders. For this reason, it may have higher interest rates, higher credit score requirements, and lower borrowing limits than secured debt.
With that said, unsecured debt may be less risky for borrowers. While you should always plan to repay your debt as agreed, lenders do not have a specific asset they can seize if you fail to repay an unsecured loan. This, of course, does not mean that unsecured loans are risk-free. If you miss a payment or end up unable to pay these debts, it could still damage your credit score, and in the worst case scenario, creditors could sue you.
What is secured debt?
Secured debt is a form of borrowing in which a collateral asset is used to secure the debt. This category typically includes loans designed for large, specific purchases, such as a home or car. Because these loans pose less risk to lenders, they typically have less stringent eligibility criteria, lower interest rates, and higher borrowing limits on average.
If the borrower defaults on this type of loan, the lender can take ownership or control of the asset and use it to recoup lost funds. (This is called foreclosure or repossession, depending on the type of loan.)
Whether it’s your home, car, or even a savings account being used as collateral, the fact that the lender can seize the asset if you don’t pay it off is what sets this type of debt apart. But this is not the only risk for borrowers. Defaulting on a secured loan will still damage your credit score, leaving you with no assets and in a worse financial situation.
Examples of each type of debt
Examples of Unsecured Debt
The better your credit history and score, the more likely you are to be approved for unsecured loan products. If you have limited credit history or even bad credit, you may be forced to choose secured credit cards or loans secured by collateral until you can demonstrate to lenders that you are not a risky borrower.
Why it matters whether your debt is secured or unsecured
When it comes to repayment, the type of credit you have determines your debt management options. With secured debt, such as a car loan or mortgage, you have the option of refinancing over time. Refinancing can help you lower your interest rate, reduce your monthly payments, take equity out of an asset as cash, remove a co-borrower, and more. Because this debt is secured by a tangible asset, there is usually no shortage of lenders who may be willing to refinance the debt. You can also refinance some types of unsecured debt, such as a personal loan or private student loan. This may be a smart move if your financial situation has improved since you took out the loan and you can now qualify for better terms.
When it comes to unsecured debt, debt consolidation is a common strategy used to get out of debt quickly. With this method, you take out a new loan, which you can then use to pay off one or more existing debts. Although you can consolidate some secured debts, this step is usually reserved for unsecured debts.
If you’re struggling to make payments, debt relief is an option for unsecured debt, but not for secured debt. With debt relief, you can work with a company to create a debt repayment plan, lower your interest rates, or, in some cases, pay off your debts for less than you owe.
Bottom line
Both secured and unsecured debt can be smart options, depending on whether you want to make a large purchase, consolidate existing credit card debt, or increase your credit score with a credit card. Secured debt may be a better option if you have limited credit history or are making a very large purchase, but it comes with risks because the debt is secured by collateral. Unsecured debt is more flexible and doesn’t put your assets at risk, but may have higher interest rates and stricter approval requirements.
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