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.
- Secured debts are those for which the borrower puts up some asset to serve as collateral for the loan.
- The risk of default on a secured debt tends to be relatively low.
- 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. For example, you will generally need a credit score of at least 670 to qualify for an unsecured personal loan.
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.
Which is better: secured 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, though, it is likely to come with a lower interest rate than unsecured debt.
What is a secured credit card?
While most credit cards are unsecured, some lenders also issue secured credit cards. With a secured card, the cardholder deposits a sum of money with the bank, which then becomes the card’s credit limit. Secured credit cards are often used by people with poor credit records or no credit history in order to establish credit and eventually qualify for a regular, unsecured card.
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.
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.