When you're planning to take on some debt, whether it be for a new vehicle or to cover larger expenses such as medical bills, it's important to understand the type of debt you're taking on. The terms and conditions of the loans needed to repay the debt could have a major impact on the choices you make going forward.
Most types of debt fall into one of two categories: secured and unsecured. While both types give you access to funds, the repayment terms are slightly different. Here’s an overview of the similarities and differences between the two, along with the best strategies for getting out of debt.
Main Differences Between Secured and Unsecured Debt
The biggest difference between these two types of debt is that secured debt requires collateral and unsecured debt does not. If you fail to pay either type of debt, your credit score could be dinged and you could face legal action.
With unsecured debt, a lender would pursue legal action in court. With secured debt, the lender would take your collateral. They could pursue legal action if your collateral doesn't cover debts owed.
Which Has Higher Interest Rates
When lenders offer loans of any kind, they are taking on some risk. If you are unable to pay off your debt for any reason, the lender could be out that cash.
They help offset their risk with an interest rate. For that reason, unsecured loans tend to have higher interest rates. Secured loans may offer better interest rates because the lender sees your collateral as a sign that you are lower risk.
Your credit score, income, and loan amount will also affect the type of interest rate you're offered.
What is Secured Debt?
When you take out a loan or line of credit with secured debt, that means you put up something as collateral. It could be money, a car, a home, a piece of art, and more.
Types of Secured Debt Include:
- Car loans
- Home loans
- Reverse mortgage
- Home equity loan
- A home equity line of credit
- Secured credit card
Example of Secured Debt
Let’s say your secured debt is in the form of owning a home worth $300,000. You owe $200,000 on the property, which means you have about $100,000 in equity (the difference between the home value and what you owe).
If you need to cover medical expenses or want to remodel your home, you could take out a home equity loan. Most lenders will only pay up to 80% of the total equity, so in this example, you could expect to be approved for a loan up to $80,000.
If you take it, the lender then uses your home as collateral, hence being a home equity loan. That means if you fail to make payments, the lender can foreclose on your property. Car loans are also considered secured loans and if you fail to make your car payments, the lender can repossess the vehicle.
How Secured Debt Affects Your Credit
Secured debt and unsecured debt are both reported the exact same way. Your credit report will list the amount of the loan, how much you owe, and your payment history.
Traditionally, lenders don't report late payments until it’s at least 30 days past due. Bills with late payments of 60 and 90 days are going to affect your credit score more, and it's also more likely that once you hit those thresholds the lender will begin to come after your collateral.
The primary difference between unsecured and secured loans is that a lender can take your property if you fail to pay. This may also be reflected in your credit report.
What Happens If You Don’t Pay Secured Debts
If you are unable to make payments on your secured loan, call your lender as soon as you know it might be an issue. Lenders may be able to work with you to skip a payment, adjust payment terms, or otherwise negotiate an option that's less damaging than a ding on your credit.
Failure to make secured debt payments could result in a damaged credit score and the loss of your collateral, something I think it’s safe to say we would all like to avoid. Your lender may send someone to take your car, home, or another item you used as collateral.
What is Unsecured Debt?
Unsecured debt is a loan or line of credit that does not require collateral or assets, meaning there are usually no tangible items attached to the debt.
Types of Unsecured Debt Include:
- Most credit cards
- Personal loans
- Student loans
- Medical debts
- Store cards
- Cell phone
Example of Unsecured Debt
One way you might obtain an unsecured debt would be if decide to apply for a debt consolidation loan. Most personal loans do not require any collateral. The lender reviews your credit history and finances and then offers you a loan for a certain amount of money. Once you sign all of the appropriate forms, the lender gives you the money and you begin repaying the loan per the terms set by your lender.
You might also find yourself swimming in credit card debt, which is also unsecured. If you don't make payments on the credit card, the lender isn't going to repossess everything you purchased with that card, but they can pursue other avenues to get their money back.
How Unsecured Debt Affects Your Credit
Like secured debts, unsecured debt is listed on your credit report by the total amount of your loan (or credit card limit), how much you owe, and your payment history.
Payments (late or otherwise) are reported the same as secured debt, and late payments have the same impact on your credit score as well.
The primary difference here is that the lender cannot take away any possession.
What Happens If You Don’t Pay Unsecured Debts
If you cannot make your debt payments, your lender could pursue a legal case against you and even garnish your wages.
Further, late payments may appear on your credit report. Late payments of 30 and 60 days may not have as much of an impact, but if you're hitting the 90-day mark, your credit score could suffer long-term damage. Once payments are 120-days past due, creditors may send your bill to collections, mark your account as a charge-off, or pursue legal action.
If you think you won't be able to make your payments, contact your lender as soon as possible to discuss possible solutions. One of the worst things you can do in this situation is to do nothing at all.
Which Type of Debt You Should Pay Off First
When paying off debt, there are a few ways to strategize which debt payments should get paid first. Each strategy has benefits, so ultimately, it's up to you to decide which option is the right fit for you.
Repayment Options to Consider
- Pay off debts with the highest interest rates first. Also known as the Avalanche Method, this will save you the most money in the long-term, and typically includes unsecured loans such as credit cards and personal loans.
- Pay off the lowest debt first, regardless of interest rates. There's something to be said about completely getting rid of one bill. You can check it off a list, see progress quickly, and take that payment and add it to your other bills. This can be a simple way to stay motivated. In this case, it's not so much the type of debt that's important, it’s the amount of debt that prioritizes the order in which you tackle payments.
- Target unsecured debt first. Unsecured debt has higher interest rates and it's not helping you. Secured debt, like student loans and home mortgages, are considered "good" debt because the recurring payments can help boost your score and show financial responsibility. As long as you can continue to make those payments on time, they can actually help boost your score.
Any option will work if you stay focused on the goal. You just have to decide which is going to be easiest for you to manage.
How to Get Help to Pay Off Debt
If you’re struggling to make debt payments, there are a lot of options ranging from DIY debt repayment strategies to debt consolidation loans to debt settlement companies. First, you need to track down what you owe, then decide how to pay it off.
Getting out of debt on your own might not always be a feasible option, depending on how much and what kind of debt you’re grappling with, but knowing the options available can help you gain a holistic understanding of how to become free of debt.
If you want professional help, combining your loans with the help of a debt consolidation company could be a useful option to consider, especially if the idea of making a single payment each month breathes a sigh of relief into you.
You may even look into considering debt settlement as an option depending on your financial situation – an option that often gets mixed up with debt consolidation. They are not the same thing.
Speaking from personal experience, getting professional help does come with risks and some surprising advice. For example, your credit score will likely be affected, some lenders may not work with the company you want to choose, and some debt relief companies will actually advise you to stop making payments completely so they can negotiate on your behalf. Before choosing, make sure you have all the details to decide if something like debt consolidation is a good idea.
Can unsecured debt become secure?
Yes. If a creditor sues you for payment, your unsecured debt (like credit cards or personal loans) could become secured. That simply means the creditor has the right to come after your property to repay your debt if a judge finds in favor of the company. It's worth noting, that in these instances, your wages and bank accounts are considered property.
Can I lose my house over unsecured debt?
Yes and no. Technically, you could lose your home if you don't pay your unsecured debt, however, the lender (or credit card company) cannot take your home if you can't make your payments.
According to the National Bankruptcy Forum, there is a process that has to happen before you would lose your house. Once you've stopped making payments, your lender will likely send your bill to collections. If the debt collector is unable to collect money from you, they may file a lawsuit. If you’re sued and lose (or you fail to respond and the judge issues a default judgment), the creditor can now come after your assets, they could even place a lien on your home. Check your state laws to find out what type of property exemptions protect you against this type of collections.
Is taking out a personal loan to pay down unsecured debt a good idea?
When you use a personal loan to consolidate debt, you get instant gratification because your bills are all neat and tidy and wrapped up in one monthly payment. However, your credit cards are now paid off and singing their siren song from your wallet. If you wrack up your credit card bills again, you'll be in even deeper debt than you were before. It’s important to avoid this at all costs after you’ve worked tirelessly to get out of debt.
Why are student loans considered unsecured?
Good question! Since secured debts are typically linked to a tangible asset, such as a home or car, if you default on your loan, the lender has the right to seize that asset. This is not the case with student loans. If you default on your loan, the lender can’t take back your education, so it’s typically classified as an unsecured debt.
That being said, some lenders have in fact made student loans with assets. Think similar to home equity loans, except with the money being directed toward educational costs. This reduces the lender’s risk and can often help secure lower interest rates on the loan.