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There are many ways to borrow money, from a simple IOU sealed with a handshake to a complex commercial debt instrument like a subordinated convertible debenture. Fortunately, almost all borrowings can be conveniently divided into two types of debt: secured and unsecured.
The difference between the two types of debt is relatively simple. A secured loan has collateral, and an unsecured one does not. A collateral is an item of value that a borrower offers to a lender as security for the loan. If the borrower does not repay the loan, the lender can seize the collateral and sell it to recover all or part of its loss.
Whether a debt is secured or unsecured is important for many reasons. It often has a significant impact on the cost of the loan. This can influence whether you can get credit. And the wisest strategy to follow when repaying debt, or the order in which you will repay your debts, is often determined by whether a debt is secured or unsecured.
Here’s more on the differences between secured and unsecured debt.
What is unsecured debt?
Unsecured debt is money borrowed without collateral. For example, if you forget your wallet at lunch and ask a co-worker to pick up your check and promise to pay it back when you get back to the office, that’s usually an unsecured debt. Your money-back promise is your co-worker’s only guarantee of getting their money back.
With unsecured debt, lenders cannot rely on the presence of collateral as a means of reducing risk and ensuring they will be paid. Instead, lenders typically look at a borrower’s creditworthiness to decide whether or not to extend a loan. unsecured loan. This usually involves reviewing the borrower’s borrowing and repayment history. Lenders can also look at the borrower’s income to predict if they have enough income to make loan payments.
Here are some other examples of unsecured debt:
Some additional types of transactions are also similar to unsecured loans. For example, when you sign a gym membership contract, you agree to pay the monthly membership fee for the duration of the contract. However, the gym does not receive any guarantees. Utility bills and taxes are other examples of unsecured loans.
If you invest in a corporate bond, you are giving the bond issuer an unsecured loan. Similarly, United States Treasury Bonds are loans to the federal government that are only secured by the government’s promise to pay.
Finally, some financial instruments are not entirely secure but have some security. For example, a bond is a debt security issued by a company that can be converted at the option of the holder into shares. The convertible subordinated debenture mentioned at the beginning of this article is an example of this type of convertible debt.
What is secured debt?
The key feature of a secured debt is that the borrower has collateral in place. It is an asset that the lender can, if the borrower defaults on the loan, repossess. Loans can be secured by all types of assets, including real estate, vehicles, equipment, securities and cash.
Here are some common examples of secured debt:
- Car, motorcycle, boat and RV loans
- Home Equity Loans and home equity lines of credit
With a mortgage, the loan is secured by real estate. If the borrower fails to make the payments, a mortgage lender can foreclose on the home and sell it to recover the loaned money. Car loans work the same way.
Usually, a secured debt is secured by the asset purchased with the proceeds of the loan. A car loan is secured by the car. Sometimes the loan proceeds can be used for other purposes. For example, you can use money from a home equity loan or home equity line of credit to pay off an unsecured credit card or medical bill.
As a general rule, the borrower explicitly undertakes to constitute the pledge as security. However, there are loans that do not identify any collateral in advance, which can lead to the seizure of collateral in the event of default. For example, if a homeowner fails to pay property taxes, the taxing authority may obtain a tax lien on the home. If the taxes are not paid, the house can be seized and sold to pay the tax bill.
Unsecured Debt vs Secured Debt
The presence or absence of collateral makes a big difference in many aspects of borrowing. Below are some of the main advantages and disadvantages of secured and unsecured debt.
Benefits of Unsecured Debt
- Generally no risk of loss of collateral if loan is not repaid. Lenders cannot take collateral directly if you fail to repay your loan.
- Unsecured loans are flexible. These loans can generally be used for a wide variety of purposes.
- The application process can be faster. Since there is no collateral assessment, the application process for unsecured loans is generally less complex.
- Unsecured credit is widely available in various forms. Credit cards, personal loans, student loans, and medical loans are all examples of unsecured loans.
Disadvantages of unsecured debt
- Unsecured loans can be harder to get. Due to the risk, lenders are likely to have stricter credit requirements for unsecured loans than for secured loans.
- Unsecured loans almost always carry higher interest rates. Interest rates on mortgages, for example, are much lower than those on credit cards. While a 30-year fixed rate mortgage may carry an interest rate of around 3%, credit cards may charge 15% to 24%.
- Lower credit limits. Unsecured debt may come with a lower credit limit. It can be difficult to borrow as much as you need without collateral.
- Missed payments can negatively impact your credit score. Even being late on a single payment can have a significant impact on a credit score. And having a patchy credit history and low credit score can restrict a borrower’s access to future credit and increase the costs of additional loans.
Benefits of Secured Debt
- It’s usually easier to get a loan. Since lenders know they can repossess the collateral (collateral), if the borrower does not pay, they are more willing to extend credit.
- Secured loan costs are generally lower. Again, because the lender does not feel as exposed to the risk of loss, a borrower can usually obtain a secured loan at a lower interest rate.
- There may be tax advantages. On certain secured loans, such as mortgages, borrowers can take advantage of tax deductions for interest payments.
Disadvantages of secured debt
- There is a risk of losing the warranty. The borrower bears this risk and, in the case of an essential asset such as a principal residence, the risk of losing the guarantee is very high.
- Secured loans may require additional insurance coverage on the collateral. For example, mortgage borrowers must have home insurance. Auto lenders require cars purchased with loans to be covered by comprehensive insurance policies. Insurance premiums are added to the cost of credit.
- Loan uses are less flexible. The uses of the loan are usually tied to collateral and therefore less flexible than unsecured loans.
How to prioritize debt repayment
Smart borrowers clearly consider whether a debt will be secured or unsecured before borrowing. But the presence or absence of collateral also figures when deciding how to repay existing debts.
A recommended approach is to pay off the debt with the highest interest rate first. This is sometimes called the debt avalanche method. Generally speaking, this often means focusing on paying off unsecured debt before paying off secured debt.
the debt snowball method takes a different approach. With this method, you typically focus on paying off the smallest amount of debt in a short period of time while continuing to make payments on your other debts, to help build momentum toward repayment.
Sometimes it is best to prioritize needs. For example, if you lose your job and have to choose between paying the mortgage and making additional payments on a credit card to reduce the high interest rate balance, it may make more sense to pay the mortgage in first. In the case of an either-or decision, making sure you have shelter takes precedence.
Similarly, if you need your car to get to work, you can choose to make sure the car payment is made before the personal loan is paid off, even if the personal loan carries a higher interest rate. .
If you find you need help managing your secured or unsecured debt, debt relief can take different forms, and one may suit your financial situation better than another. Be sure to explore all of your options before deciding on a method.
Unsecured and secured debt both involve a promise to pay, but one carries much more substantial penalties if that promise is not fulfilled. You may be able to get more credit using secured credit, and the cost may also be lower. But unsecured credit also has some advantages.
It is important to fully understand the difference between unsecured debt and secured debt before taking out a loan. Understanding how they differ and the pros and cons of each can guide you when making financial decisions, giving you a better chance of achieving your financial goals.
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