At some point in your life, you will likely need to borrow money. When you do, it will be in one of two forms: secured or unsecured.
Unsecured debt is a common form of borrowing that includes traditional credit cards, student loans and medical debt. This type of borrowing is often quicker and easier than applying for secured debt.
“Unsecured debt does not involve any collateral,” says Bruce McClary, senior vice president of media relations and membership for the National Foundation for Credit Counseling. “Approval is based on creditworthiness, and the loan or line is opened with a signature of the borrower — nothing else is needed.”
Because there is no collateral, sometimes interest rates can be higher. Learn more about unsecured debt and when it might be the right choice for you.
Unsecured vs. Secured Debt
The main difference between unsecured and secured debt is that secured debt requires collateral: a valuable asset such as a car, home or savings account the lender can seize if the borrower defaults. “Collateral is released back to the borrower once loan is paid,” McClary says. “But if the borrower does not repay according to the terms, lenders can take the collateral from the borrower and sell it to recover losses.”
Unsecured debt is issued based on credit and not backed by assets of any kind, which places the lender at greater risk of not being repaid. Lenders typically offset this risk by charging higher interest rates on unsecured debt and sometimes having more stringent qualifications for borrowing.
As such, it’s typically easier for consumers with poor credit to qualify for small secured loans. “Auto title loans usually require no credit check at all,” says Michael Sullivan, personal financial consultant with Take Charge America, a national nonprofit credit counseling and debt management agency.
Risk-wise, there is more at stake for consumers who take secured loans. “If you default on a mortgage, you lose your house. If you default on an auto loan, you lose your vehicle,” Sullivan says. In addition, you may still be responsible for the difference between what you owe and the value of the collateral repossessed, and your wages could be garnished to repay that amount and any fees.
Examples of unsecured debt:
— Medical bills
— Personal loans
Examples of secured debt:
— Home equity loans
How Creditworthiness Impacts the Cost of Borrowing
Your credit score is a top factor lenders use to determine your eligibility for an unsecured loan and set your interest rate. Because unsecured debt poses bigger risks to lenders, borrowers usually need higher credit scores to qualify compared with secured loans. Strong credit suggests that the borrower has a track record of meeting their debt obligations.
“Your creditworthiness is more important for unsecured debt because you’re approaching the lender and asking for a loan,” McClary says. “You’re not offering anything other than your credit history and capacity to repay as proof that you’ll honor the loan agreement.”
By contrast, people who do not have an extensive borrowing history or who have poor or no credit scores are less likely to qualify for unsecured debt. If a lender offers an unsecured loan to a borrower with a limited or troubled credit history, the loan will typically come with a low credit limit and high interest rate.
Credit score becomes more important with higher loan amounts as well, Sullivan says. “Someone with a 500 FICO score can probably get a $1,000 unsecured credit card with a high interest rate, but that same consumer could probably not get a $100,000 secured home mortgage at any interest rate,” he says.
People who are credit-challenged should also be aware of predatory lenders that seek to take advantage of those desperate for funding. Some of these loans can have triple-digit APR, high fees and other unfavorable terms.
[Read: Best Personal Loans.]
Is Unsecured or Secured Debt Better?
Which loan type is better can depend on your credit, your financial need and your willingness to put assets at risk. In general, though, no one should take a secured loan if they can get an unsecured loan with similar terms, Sullivan says.
For example, many people use home equity loans to pay off credit cards. “By doing so, they are putting their home at risk” by using it as collateral, he says. “The savings from doing that rather than using a personal loan or a new credit card must be substantial to warrant the additional risk.”
If you don’t have assets to provide as collateral, an unsecured loan may be your only option. But if you don’t have good credit, a secured loan could offer easier approval. When deciding what’s best for you, consider the distinct advantages and disadvantages of unsecured and secured debt.
For example, if you’re trying to get the lowest interest rate possible, a secured loan can help with that, but that doesn’t mean it’s the best move. Assuming there are no prepayment penalties on an unsecured loan, you may be able to offset the impact of a higher interest rate over the full term by paying the loan off faster, McClary says. “That can be a game-changer. You won’t have to put up collateral, and even though the face value interest rate is higher, your overall cost may be less than a secured loan.”
On the other hand, putting up collateral might be your preference. Just be aware of the potential consequences and think through the worst-case scenarios, which may include the lender repossessing the property you pledged as collateral.
An unsecured loan may be best when:
— You have good or excellent credit.
— You don’t have or don’t want to pledge collateral.
— You don’t require a large loan amount.
A secured loan may be best when:
— You have fair or bad credit.
— You want the lowest possible interest rate.
— You need a large loan amount or long repayment term.
— You are willing to pledge an asset as collateral.
[Estimate: Your Monthly Payments with Our Loan Calculator]
What Happens if You Fail to Pay Unsecured Debt?
For unsecured debt, most lenders provide a grace period before reporting late payments to the credit bureaus. You can expect late fees and a drop in your credit score. After that, your account will likely be sent to collections after a period of time. In a worst-case scenario, the lender might even sue you to try to collect the debt.
“If you fall two payments past due, you may hear from the collections department of the lender or creditor to talk to you about getting the account back on track,” McClary says.
But once you get to three or four missed payments, you run a high risk of the lender shutting down the line of credit and possibly sending it to a third-party debt collection agency. “If you don’t work out payment or settle the debt, they may consider taking legal action,” he says.
Beside the financial and legal repercussions, your credit health is also on the line if you fail to pay unsecured debt. “It can have an impact on your credit score, and that can take a while to recover,” McClary says. “You don’t want to create that kind of work for yourself in digging that hole.”
If you default on a debt, regardless of type, it remains on your credit report for up to seven years and hurts your ability to borrow in the future.
Which Type of Debt Should You Pay Off First?
Plan to make at least the minimum payment, regardless of whether a debt is secured or unsecured. But if you struggle to pay both secured and unsecured debts and wonder how to prioritize paying them off, think about prioritizing your well-being, Sullivan says.
“Every situation is a bit different, but it is almost always more important to focus on secured debt to protect assets,” he says. “Many consumers prioritize car payments because they cannot work without a vehicle. Some prioritize mortgage payments to protect the equity in a home and having a place to live.”
The best thing to do is ask all creditors for patience when it becomes impossible to pay bills. Many lenders offer hardship plans and other forms of assistance. But some creditors respond aggressively in an attempt to get paid before others, and it is important to make payments according to your priorities, not according to who calls the most, Sullivan says.
If you’re fortunate to have creditors that offer you a short reprieve, that can help you decide how to proceed. “Then you can make an informed decision if it comes down to which one you may have to short,” McClary says. When in doubt, nonprofit credit counselors can help offer guidance, he says, and the first session is typically free. “It’s a great resource you can use in the early stages to get things on track,” he says.
More from U.S. News
Is Debt Consolidation a Good Idea?
Can You Get a Personal Loan With Low Income?
Can You Get a Personal Loan When You’re Self-Employed?
What Is Unsecured Debt? originally appeared on usnews.com
Update 08/07/24: This story was previously published at an earlier date and has been updated with new information.
