When people think about their debt, they often lump it all into one category. They don’t consider there are actually two types of debt – secured and unsecured – and even subcategories within these two types.
In simple terms, secured debts are those that require assets to be held as collateral, such as a house for a mortgage or a car for an auto loan. Because lenders take less risk because the collateral “secures” the loan, these loans are typically easy for most consumers to get. With unsecured debts, creditors issue loans solely on the basis of the borrower’s creditworthiness and promise to repay. If you fail to pay off an unsecured debt, the lender cannot take any of your property without first suing you and getting a court judgment, according to Nolo.
It is important to distinguish between debt types because it makes a difference in your interest rates, credit score, monthly payments, potential loss of collateral and income tax filing.
Comparing secured and unsecured debts
Here’s how secured and unsecured debts differ:
- Interest rate. The interest rate on secured debt is frequently lower than it is on unsecured debts, because the latter is more of a risk for lenders. Unsecured debt rates can be very steep depending on your credit score and ability to repay.
- Credit score. You frequently need a higher credit score to obtain a secured loan than an unsecured loan. As you make your monthly payments and prove your creditworthiness, you improve your credit score with both types of debt.
- Monthly payment. Your monthly payment is a consistent, preset amount, allowing you to plan accordingly. As “revolving” credit, your unsecured payments usually differ each month, making budget planning more difficult.
- Potential loss of collateral. Because secured debt uses property or goods (such as a house or car), you risk forfeiting that collateral if you do not repay the debt. With unsecured debt, there is no such collateral to lose.
- Income tax filing. Some secured debt – most notably home loan mortgages – offer you income tax breaks in that you can deduct the interest. You cannot deduct interest payments from unsecured debt on your taxes, with the exception of some but not all student loans.
The ‘good’ debt equation
You might have thought no debt could be considered “good” debt. However, certain kinds of loans, both secured and unsecured, are considered “good debt” if they help you generate income and increases your net worth. Examples of good debt include mortgages (secured), student loans and small-business loans (both unsecured).
Unsecured debts further defined
With unsecured debt, you apply for and receive a loan based on your credit history, credit score and ability to repay. Because you aren’t “putting up” anything, creditworthiness is a key factor in obtaining unsecured loans. Some specific categories of unsecured debt are:
Credit cards. Credit cards are the most common type of revolving debt. Revolving debt allows you to borrow against a predetermined line of credit and pay at least the minimum due each month. The monthly minimum fluctuates depending on the current outstanding balance. When you increase the balance owed, a higher minimum amount is due. It is best to pay more than the minimum payment to keep interest rate costs at a minimum over time, and ideally pay the bill off in full each month.
Signature loans. These are a type of personal that are just what the name implies: loans secured by nothing but your signature promising to repay. These are usually installment loans in which you make equal monthly payments until you pay the principal and interest in full.
Payday loans. A payday loan is a unique type of unsecured loan. It isn’t a revolving debt – though some who get caught up in the payday loan cycle make it seem that way – and it isn’t an installment debt. The purpose of a payday loan is to advance you a one-time sum of money that you repay when you receive your next paycheck. To learn more and to make comparisons, SuperMoney has payday loan reviews here.
Peer-to-peer loans. These allow you to borrow from individuals instead of traditional lenders. Prosper is a leader in this category.
The bottom line
Regardless of the type of loan you obtain, defaulting on any debt may lead to penalties, fees and potential collection efforts. Retain your good credit rating by keeping your unsecured and secured debt under control. To learn more about loans, start at our loans review page, and also check out our credit card reviews page.