What is the difference between secured and unsecured debts?
Lending products available to consumers fall under two main categories: secured and unsecured debt. While a lender evaluates a consumer's credit history before making a loan under either circumstance, creditworthiness is more important to a lender giving out unsecured debt. This is because unsecured debt is issued to a borrower with no collateral taken as security against non-repayment. Secured debts are those in which some asset is given up by the borrower as collateral with a promise to repay the debt. This is the most basic explanation to differentiate the two types of debt, but there are other characteristics unique to each.
Secured debt financing is typically easy for most consumers to obtain. Lenders take on less risk by lending on terms that require an asset held as collateral. As this type of loan carries less risk for the lender, interest rates are usually lower for a secured loan. A prime example of a secured debt is a mortgage, where the lender places a lien, or financial interest, on the property until the loan is repaid in full. If the borrower defaults on the loan, the bank can seize the property and sell it to recoup the funds owed. Lenders often require the asset be maintained or insured under certain specifications to maintain the asset's value. For example, a mortgage lender requires the borrower to protect the property through a homeowner's insurance policy. This secures the asset's value for the lender until the loan is repaid. For the same reason, a lender who issues an auto loan requires certain insurance coverage so that in the event the vehicle is involved in a crash, the bank can still recover most, if not all, of the outstanding loan balance.
Unsecured debt is the opposite of secured debt, and, like its name, it requires no security for the loan. Lenders issue funds in an unsecured loan based solely on the borrower's creditworthiness and promise to repay. In days past, loans were issued this way with a simple handshake. If a borrower fails to repay the loan, the lender can sue the borrower to collect the amount owed, but this can take a great deal of time, and legal fees can add up quickly. 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 they are only made available to the most credible borrowers. Other examples of unsecured debts outside of loans from a bank include credit cards, medical bills and certain retail installment contracts such as gym or tanning memberships. Credit card companies issue consumers a line of credit with no collateral requirements but charge hefty interest rates to justify the risk.