When people think about their debt, they often lump it all into one category. They don’t consider the fact that there are actually two different types of debt – secured debt and unsecured debt – and sub-categories within these two types.
It is important to distinguish between debt types because they can make a difference in your:
- Interest rate
- Credit score
- Monthly payment
- Potential loss of collateral
- Income tax
Secured Debt is Considered Good Debt
You’ve probably never thought of debt as being good. However, if you have secured debt you generally are in a better financial position than if you have unsecured debt. Here’s why:
- Interest rate. The interest rate on secured debt is frequently lower than with an unsecured debt.
- Credit score. You frequently need a higher credit score to obtain a secured loan; and as you make your monthly payments and prove your creditworthiness, you improve your credit score.
- Monthly payment. Your monthly payment is a consistent, pre-set amount. While this allows you to plan accordingly, if your life situation changes, you lose flexibility to adjust your monthly payment to meet your new needs.
- Potential loss of collateral. Since secured debt uses collateral, it reduces the risk to the lender. Collateral is property or goods, such as a house or car, used as security against the loan. If you do not repay the debt, you risk forfeiting the collateral.
- Income tax. Some secured debt – most notably home loan mortgages – offer you income tax breaks.
In the world of business, a secured loan may be referred to as an asset-based loan. For consumers, home loan mortgages and car notes are categories of secured debt.
Unsecured Debt Gets Many Consumers Into Trouble
Unsecured debt is just the opposite of secured debt. It doesn’t require collateral to obtain a loan. You apply for and receive a loan based on your credit history, credit score, and ability to repay. There are three general categories of unsecured debt:
Revolving. Credit cards are the most common type of revolving debt. Revolving debt allows you to borrow against a pre-determined line of credit and make flexible monthly payments based on what you can afford to pay as long as you meet the set monthly minimum. The monthly minimum will fluctuate depending on the current outstanding balance, which you may increase by spending more. When you increase the balance owed, a higher minimum amount is due each month.
Installment. An installment loan is a consumer loan in which you make equal monthly payments until you pay the principal and interest in full. Personal loans, student loans, medical bills, utilities, and even home and car loans are installment debts.
Pay Day loan. 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.
Here’s how an unsecured loan impacts your:
- Interest rate. The interest rate for an unsecured debt can often be very steep depending on your credit score, credit history, and ability to repay.
- Credit score. Just as with secured debt, your credit score will influence the amount of unsecured debt you may obtain. You can improve your credit score by making your regular monthly payments.
- Monthly payment. Unlike a secured loan that requires a consistent payment each month, unsecured debt offers you a revolving plan and, therefore, a flexible monthly payment.
- Potential loss of collateral. There is no collateral to secure the debt, so there is no potential for loss. However, if you don’t repay an unsecured debt, you can ruin your credit rating and your chances of obtaining future loans.
- Income tax. In most cases, unsecured debt is not tax deductible. The exception is student loans. Investigate fully to see if there are tax breaks for your student loan.
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.