There Are Two Different Types of Debt-and Understanding What They Are Can Save You a Lot of Money
Understanding the difference between secured vs. unsecured debt can help you understand your borrowing options and even help put you on the path to healthier finances.
Whether it's a college loan, an auto loan, or a personal loan, debt means handling payments and interest. But did you know that some types of debt are better for a borrower than others? Here we'll dive into the differences between secured and unsecured debt and how making the right decision between the two can add up to savings for borrowers.
Secured debt is any kind of debt that allows a bank to swoop in and take what's yours if you fail to pay up. Secured debt includes collateral—think foreclosures on mortgages and auto loans.
"In the event that the borrower stops making payments, the lender has the right to take ownership of the collateral," says Lauren Anastasio, a certified financial planner with SoFi. "A lender typically gives the borrower notice that they have defaulted on their loan and allows them the opportunity to become current in their payments."
Secured debt also includes loans you take out against your home or car, including a home equity line of credit (HELOC), says Mike Kinane, head of U.S. Bankcards at TD Bank.
"Secured debt typically has a lower interest rate because the risk to the lender is lower," Kinane said. "For secured debt, the biggest risk is that whatever you've secured with your loan can potentially be taken away."
Secured debt gives banks the upper hand when it comes to using that collateral, but the borrower ultimately benefits, too, with lower interest rates. And, assuming you keep up with payments, you won't have to worry about losing your home or vehicle.
Unsecured debt is less tangible than secured debt because there's no collateral—think personal loans (for almost any purpose) and student loans.
"With unsecured debt, a borrower doesn't have to offer collateral in order to qualify, which means the lender is taking on more risk," Anastasio says. "A lender relies on the borrower's creditworthiness in order to determine whether to approve the loan."
Examples of unsecured debt include credit cards and personal loans, which don't allow a lender to repossess anything, Anastasio says. Because unsecured debt comes with a higher risk for the lender, you'll typically see higher interest rates. And just because you can't have your college degree taken away for failure to pay off student loans doesn't mean you won't face consequences for not paying back an unsecured debt.
"While a borrower doesn't risk losing collateral, the lender still has the right to take steps to collect the debt," Anastasio says. "Failure to pay back the loan can also severely impact a borrower's credit score, and the damage can last for years."
While you can't avoid higher interest rates for unsecured loans, Kinane points out that you aren't locked into a rate forever.
"Rates for credit card debt are typically variable, which means you're not locked in and it can change throughout the life of the debt," he says.
The debt that works best for you
Now that you've learned the differences between secured and unsecured debt, you can explore which is best for you. The lower rates for secured debt may be enticing, even with the need for collateral, but there are some ways to make unsecured debt work for you.
"What's better for the borrower will depend on what they are doing with the funds. If a consumer is looking to get a mortgage or a car loan, they don't have a choice—a secured loan is their only option," Kinane says. "However, whether you're looking to go on vacation or remodel your kitchen, the type of debt you take on will depend on your own unique personal situation and will vary depending on a number of factors. It's always best to consult with a bank or financial institution when making an important, long-reaching fiscal decision."
Anastasio says there is technically a way to purchase a home, for example, using unsecured debt, but it's much more difficult than taking the secured route.
"Due to federal regulations, most lenders will not lend on an unsecured basis if they know the intent is to use funds to purchase real estate," she says. "A buyer can use proceeds from a personal loan or unsecured line of credit to put a down payment on a property, or buy a low-cost home, but in many cases a lender is prohibited from providing new unsecured debt for this purpose, and the financing will be harder to obtain, and often much more expensive, than simply going through the mortgage process."
Anastasio says you also can't switch your debt types from one to the other after taking out a loan or making a large purchase. Still, there is an option of refinancing your loans so that you end up with more secured debt than unsecured debt, ultimately saving money with lower interest rates.
"For example, if you have credit card debt, you can't call your credit card issuer and ask them to put your car up as collateral for your credit line. You can, however, obtain a HELOC if you have equity in your home, or a 401k loan if you have a balance in your 401k plan, and use the proceeds to pay off your credit card," Anastasio says. "Your credit card will always be unsecured, but by refinancing the debt you've transitioned from having an unsecured, high-interest debt to having a secured balance at a lower interest rate."
A home equity line of credit might be a better option for consolidating debt than other types of unsecured debt, such as credit cards. If you think you qualify for a home equity line of credit, research lending options to see what kind of fees and interest rates you may face. Just be sure to look at the fine print before signing.
"A home equity line of credit is similar to a secured loan as it gives the borrower access to a line of credit that they can draw from, using their home as collateral," Anastasio says. "The amount of the line of credit is determined by the mortgage lender and is based on the amount of equity a homeowner has built. Lenders usually limit the line of credit to around 80 to 90 percent of the equity amount."