Unsecured vs. Secured Debts: An Overview
Loans and other financing methods available to consumers generally fall under two main categories: secured and unsecured debt. The primary difference between the two is the presence or absence of collateral, which is backing the debt and a form of security to the lender against non-repayment from the borrower.
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 collect what is owed.
Lenders issue funds in an unsecured loan 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 they are only made available to the most credible borrowers.
- Unsecured debt has no collateral backing.
- Lenders issue funds in an unsecured loan based solely on the borrower's creditworthiness and promise to repay.
- Secured debts are those for which the borrower puts up some asset as surety or collateral for the loan.
- The risk of default on a secured debt, called the counterparty risk to the lender, tends to be relatively low.
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 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 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.
However, the rate of interest on various debt instruments is largely dependent on the reliability of the issuing entity. An unsecured loan to an individual may carry astronomical interest rates because of the high risk of default, while government-issued Treasury bills (another common type of unsecured debt instrument) have much lower interest rates. Despite the fact that investors have no claim on government assets, the government has the power to mint additional dollars or raise taxes to pay off its obligations, making this kind of debt instrument virtually free of any default risk.
Secured debts are those for which the borrower puts up some asset as surety or collateral for the loan. A secured debt instrument simply means that in the event of default, the lender can use the asset to repay the funds it has advanced the borrower.
Common types of secured debt 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, the loan issuer eventually acquires 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 funds owed.
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.
The risk of default on a secured debt, called the counterparty risk to the lender, tends to be relatively low since the borrower has so much more to lose by neglecting his financial obligation. Secured debt financing is typically easier for most consumers to obtain. Since a secured loan carries less risk to the lender, interest rates are usually lower than for unsecured loans.
Lenders often require the asset to be maintained or insured under certain specifications to maintain its value. For example, a home mortgage lender often requires the borrower to take out homeowner’s insurance. By protecting the property, the policy secures the asset's worth for the lender. For the same reason, a lender who issues an auto loan requires certain insurance coverage so that if the vehicle is involved in a crash, the bank can still recover most, if not all, of the outstanding loan balance.