When you have debt, you have one of two types – secured or unsecured. Before you take on any debts, it’s important to understand the difference so that you know what is at stake.
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Keep reading to learn how each work and the differences between the two.
What are Secured Debts?
As the name suggests, secured debts are tied to an asset. For example, a mortgage is a secured debt that is tied to your home. A car loan is a secured debt that is tied to your car. A secured debt requires you to put up collateral.
If you don’t make your payments on time, the lender has the right to take that asset or collateral. For example, if you don’t pay your mortgage, the lender can foreclose on your home. If you don’t make your car payment, the lender can repossess your car.
With a secured debt, you aren’t the true owner of the asset until you don’t owe any more money on the debt. In the case of a mortgage, you’ll have equity in the home, but you won’t own the home free and clear. For example, if you have a home that’s worth $200,000 and you have a $100,000 mortgage on it, you have $100,000 in equity. If you sold the home right now, you would walk away with around $100,000 after paying the mortgage balance in full.
What are Unsecured Debts?
Unsecured debts, again as the name suggests, are debts that aren’t tied to any collateral. If you stop making payments on the debt, the lender can’t take any of your assets. They can, however, file a lawsuit or judgment against you in order to receive payment.
The most common unsecured debts are credit cards. You apply for a credit line and you don’t have to put up any collateral. The credit card company bases your credit line on your income, employment, and assets. A personal loan from a bank is usually an unsecured debt as well. Unsecured debts often have higher interest rates in order to make up for the risk of default and lack of collateral.
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The Difference Between Secured and Unsecured Debt
We touched upon the major differences between secured and unsecured debt above, but we’ll go into a little further detail below:
- The basis lenders use to determine your ability to obtain unsecured debt is your creditworthiness. They look at your income, assets, and credit score. They use this information to determine your likelihood to repay the debt.
- The basis lenders use to determine your ability to obtain secured debt is your creditworthiness along with the value of the collateral. Your creditworthiness determines your ability to repay the debt. The value of the collateral determines the maximum amount the lender can provide you. Lenders typically loan a maximum percentage of the asset’s value.
- Unsecured debt may be a little harder to qualify for since there isn’t any collateral for the lender to use as security. If you default on unsecured debt, the lender is on the hook for your loan amount unless they send your account to a collection agency or file a lawsuit.
- Secured debt often has more relaxed guidelines because you have to put up collateral for the debt. You are more likely to pay the debt back since you have something to lose, such as a car or house.
- You typically have to secure insurance on the collateral for secured debt. You don’t have to have any special insurance for unsecured debt. Examples of the required insurance include homeowner’s and auto insurance.
Secured and unsecured debt have their differences. While you’ll typically pay higher interest rates for unsecured debt, you don’t put any of your assets at risk. Secured debt, on the other hand, does have lower interest rates, but you put your collateral at risk if you don’t pay it.