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. Secured loans are typically cheaper and easier to get because lenders take on less risk. With unsecured debts, creditors determine eligibility based on the borrower’s creditworthiness and promise to repay. If you fail to pay off unsecured debt, the lender cannot take any of your property without first suing you and getting a court judgment.
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 vs. unsecured debt
Here’s how secured and unsecured debts differ:
- Interest rate. The interest rate on secured loans is usually lower than it is for unsecured loans. Interest rates on unsecured debt vary dramatically depending, among other things, on your credit score and income.
- Credit score. All things being equal, you 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 what you pay every month toward your loan or line of credit. Installment loans will usually have a fixed monthly payment while the monthly payment of lines of credit can vary from month to month. This can make 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. In some cases, you can deduct the interest you pay on secured loans – most notably home loan mortgages. However, 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 think no debt could possibly be considered “good.” 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 and secured).
Unsecured debts further defined
Unsecured loans don’t require borrowers to debt, you apply for and receive a loan based on your credit history, credit score, and ability to repay. As you aren’t providing any collateral, lenders will probably consider your credit more closely than if you were applying for a secured loan. There are several types of unsecured credit, such as:
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 only pay a monthly minimum. 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 at a minimum. Ideally, you should pay the entire balance every month.
Signature loans. These loans are secured by nothing but your signature. You don’t have to provide collateral or make a deposit. 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. However, those who get caught up in the payday loan cycle may beg to differ. 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 compare terms, check SuperMoney’s payday loan reviews here.
Marketplace loans. Marketplace platforms, such as LendingClub and Prosper, connect borrowers directly with investors and institutional lenders, which offers an alternative to traditional lenders.
The bottom line
Regardless of the type of loan you obtain, defaulting on any debt may lead to penalties, fees, collection efforts. Protect your good credit by keeping your unsecured and secured debt under control.