Loans and other types of financing available to consumers generally fall into two main categories: secured debt and unsecured debt. The primary difference between the two is the presence or absence of collateral to protect the lender in case the borrower defaults.
Key Takeaways
- Secured debts are those for which the borrower puts up some asset to serve as collateral for the loan.
- The secured loans lower the amount of risk for lenders.
- Unsecured debt has no collateral backing.
- Lenders issue funds in an unsecured loan based solely on the borrower’s creditworthiness and promise to repay.
- Because secured debt poses less risk to the lender, the interest rates on it are generally lower.
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What Is Secured Debt?
Secured debts are those for which the borrower puts up some asset as collateral for the loan. A secured debt simply means that in the event of default, the lender can seize the asset to collect the funds it has advanced the borrower.
Common types of secured debt for consumers are mortgages and auto loans, in which the item being financed becomes the collateral for the financing. With a car loan, if the borrower fails to make timely payments, then the loan issuer can eventually acquire ownership of the vehicle. When an individual or business takes out a mortgage, the property in question is used to back the repayment terms; in fact, the lending institution maintains equity (financial interest) in the property until the mortgage is paid in full. If the borrower defaults on the payments, the lender can seize the property and sell it to recoup the money it is owed, or at least some portion of it.
A home equity loan or a home equity line of credit (HELOC) is another type of secured debt, also backed by the borrower’s home. Homeowners who have sufficient equity can have both a traditional mortgage and a home equity loan or HELOC on the same property at the same time.
Similarly, businesses may take out secured loans using real estate, capital equipment, inventory, invoices, or cash as collateral.
Because of their reduced risks, secured loans generally have more lenient credit requirements than unsecured ones. For example, a credit score of 620 is generally considered adequate for obtaining a conventional mortgage, while government-insured Federal Housing Administration (FHA) loans set the cutoff even lower, at 500. As with unsecured loans, however, the better your score, the lower your interest rate may be or the more money you may be allowed to borrow.
The primary difference between secured and unsecured debt is the presence or absence of collateral—something used as security against non-repayment of the loan.
What Is Unsecured Debt?
Unsecured debt has no collateral backing: It requires no security, as the name implies. If the borrower defaults on this type of debt, the lender must initiate a lawsuit to try to collect what it is owed.
Lenders issue unsecured loans based solely on the borrower’s creditworthiness and promise to repay. Therefore, banks typically charge a higher interest rate on these so-called signature loans. Also, credit score and debt-to-income requirements are usually stricter for these types of loans, and the loans are only made available to the most attractive borrowers. While some personal loans are available to those with a lower score, a 670 credit score is typically needed for access to a broad range of favorable personal loans.
However, if you can meet the rigorous requirements, you could qualify for the best personal loans available.
Outside of loans from a bank, examples of unsecured debts include medical bills; certain retail installment contracts, such as gym memberships; and outstanding balances on most credit cards. When you acquire a piece of plastic, the credit card company is essentially issuing you a line of credit with no collateral requirements. But it charges hefty interest rates on any money you borrow to justify the risk.
An unsecured debt instrument like a bond is backed only by the reliability and credit of the issuing entity, so it carries a higher level of risk than a secured bond, its asset-backed counterpart. Because the risk to the lender is increased relative to that of secured debt, interest rates on unsecured debt tend to be correspondingly higher.
Unsecured government debt can be a special case. For example, U.S. government-issued Treasury bills (T-bills), while unsecured, have lower interest rates than many other types of debt. That is because the government has the power to print additional dollars or impose taxes to pay off its obligations, making this kind of debt instrument virtually free of any default risk.
Advantages of Secured and Unsecured Debt
Although each type of debt has been discussed above, let's cover the advantages of each more specifically.
Pros of Secured Debt
Here are the advantages of secured debt:
- The presence of collateral, such as real estate or valuable assets, provides lenders with a greater sense of security. This means the interest rate you get will probably be lower.
- Because interest rates are most likely lower, your monthly payments may be slightly lower with secured debt.
- Secured loans are often easier to get, especially for people with lower credit scores or limited credit history, as the secured asset can help validate the possibility of future debt payments.
- Secured debt may come with longer payment terms; lenders may be willing to have these longer terms because of the secured asset. This means people can have a little less pressure on their monthly cash flow.
Pros of Unsecured Debt
Here are the advantages of unsecured debt:
- Because unsecured loans do not require collateral, people don't have the risk of losing specific assets in case of default.
- The freedom from collateral may streamline the application process, possibly leading to quicker approvals. This is because there is no substantiation of assets being secured.
- Unsecured loans usually provide borrowers with the flexibility to use the funds as needed. Alternatively, secured loans may be tied to the underlying asset (i.e., a car loan must be used to buy a car, the secured asset).
Unsecured Loans With Favorable Terms
Sometimes well-qualified borrowers can be given an unsecured loan with favorable terms more similar to a secured loan.
In this situation, lenders assess the borrower's credit history, income, reputation, and financial situation as a basis for granting a loan. However, unlike secured loans, no collateral tied to tangible assets like real estate or vehicles is put down. The lender is still willing to grant favorable terms and interest rates based on a business or individual's reputation and stability, for example. This is an unsecured loan, yet the lender is agreeing to favorable terms (often reserved only for secured loans).
This scenario is particularly advantageous for those who want great loan terms without risking specific assets. This may be difficult to achieve, however, as the lender is extending favorable loan terms without having a secured asset to reduce its risk exposure.
Secured Credit Cards
Note that in some cases, a traditionally unsecured loan may be secured in the interim while the debtor builds credit or fosters the relationship with a lender. One example of this is secured credit cards.
Secured credit cards are a type of credit card that requires the cardholder to provide a cash deposit as collateral. If you've never heard of this before, it's because most credit cards often do not require a secured asset. When the credit card is issued, the credit limit is often equal to the amount of the deposit.
Successfully managing this secured credit card, making regular payments, and keeping balances low relative to the credit limit can positively impact the cardholder's credit score. In addition, more credit may be issued (without needing a secured asset) or the secured asset may be relinquished to convert the card to an unsecured line of credit.
Secured and Unsecured Debt in Investing
Let's quickly touch on how secured and unsecured debt matters from the investor's perspective. If you are invested in bonds or corporate debt, you are invested in either secured or unsecured debt.
Investors holding both secured and unsecured debt in their portfolio benefit from risk diversification, especially realizing that unsecured debt is riskier. Secured debt, backed by collateral, offers a lower risk of default; however, because the rates are often lower, your potential return will also be lower.
There are also other investing things to keep in mind. For example, as mentioned earlier, secured debt may have longer terms. This means secured debt may leave you more exposed to interest rate risk as rates may fluctuate greater over the long term compared to the short term.
Which Is Better: Secured Debt or Unsecured Debt?
From the lender’s point of view, secured debt can be better because it is less risky. From the borrower’s point of view, secured debt carries the risk that they’ll have to forfeit their collateral if they can’t repay. On the plus side, however, it is more likely to come with a lower interest rate than unsecured debt.
Are Personal Loans Secured or Unsecured?
While personal loans are generally thought of as unsecured, they can be either. Examples of the type of property that might be used as collateral for a secured personal loan include cars, boats, jewelry, stocks and bonds, life insurance policies, or money in a bank account.
Does Secured Debt or Unsecured Debt Have Higher Rates?
Because unsecured debt is more risky since it is not backed by secured assets, it will often charge borrowers higher rates.
Can I Combine Secured and Unsecured Debts?
Debt consolidation involves combining multiple debts into a single, more manageable loan. By using a secured loan (such as a home equity loan) to pay off high-interest unsecured debts, borrowers can potentially lower overall interest costs and simplify repayments. People usually do this to not only simplify their debt portfolio but also to reduce what they pay in interest.
The Bottom Line
Loans may be secured or unsecured. Secured loans require some sort of collateral, such as a car, a home, or another valuable asset, that the lender can seize if the borrower defaults on the loan. Unsecured loans require no collateral but do require that the borrower be sufficiently creditworthy in the lender’s eyes. Generally speaking, secured loans will have lower interest rates than unsecured ones because of their lower perceived risk.
