What is Unsecured Debt?

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The difference between secured and unsecured debt and which you should pay first

There are two general categories of debt: unsecured debt and secured debt. The difference is very important.

Knowing the difference will help you recognise each type of debt and develop a smart debt repayment strategy when you have both secured and unsecured debts. Here is a closer look.

What is unsecure debt?

Unsecured credit means the bank or the lender doesn’t have any asset to hold onto in exchange for giving you a loan. The risk for the lender in this instance is much higher than secured credit and therefore the lender needs to attach a higher interest rate to these loans. However, unsecured credit is useful when you need to cover an emergency expense or smaller expenses such as furniture, travel or electronic goods. Examples of unsecured credit are credit cards, microloans, personal loans and retail store accounts. Basically, they’re accepting your promise to pay them back in the future. That’s why unsecured loans are usually based on your credit history and payment behaviour amongst other factors applied by the lender.

Here are some other examples of unsecured debts:

Credit cards
Personal loans
Medical bills
Student loans

Some additional kinds of transactions are also similar to unsecured loans. For instance, when you sign a contract to belong to a gym, you promise to pay the monthly membership fee for the length of the contract. However, the gym doesn’t get any collateral. Utility bills and taxes are other examples of unsecured loans. If you invest in a corporate bond, you are giving the bond’s issuer an unsecured loan. Similarly, United States Treasury bills are loans to the federal government that are secured only by the government’s promise to pay. Finally, some financial instruments are not entirely secured but have some security. For instance, a bond is a debt security issued by a corporation that can be converted at the holder’s option to shares of stock. The convertible subordinated debenture mentioned at the start of this article is an example of that kind of convertible debt.

What is secured debt?

In simple terms, secured credit means the bank, or the lender, holds one of your assets in exchange for giving you the loan – like your car, or your home. So your home is the ‘security’ for your home loan: if you don’t pay your bond, the bank will sell your house to cover the money they lent you. The same applies to your car.

Common examples of secured debts include:

Mortgages
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 home mortgage lender can foreclose on the home and sell it to recoup the loaned money. Vehicle loans work the same way. Usually, a secured debt is secured by the asset purchased by the proceeds of the loan. A car loan is secured by the car. Sometimes, the proceeds of the loan may be used for some other purpose. For instance, you could use money from a home equity loan or home equity line of credit to pay off an unsecured credit card or medical bill. Generally, the borrower explicitly agrees to put up the collateral as security. However, there are loans that don’t identify any collateral upfront that can result in collateral being seized in the event of default. For example, if a homeowner fails to pay property taxes, the taxing authority may obtain a tax lien against the home. If the taxes aren’t cleared up, the home may be seized and sold to pay the tax bill. The presence or absence of security makes a big difference in many aspects of borrowing. Below are some of the key pros and cons of secured and unsecured debt.

The Pros and Cons

Unsecured Debt the pros

Generally, no risk of loss of collateral if the loan isn’t repaid. Lenders can’t directly seize the collateral if you default on your loan.
Unsecured loans are flexible. These loans can generally be used for a wide range of purposes.
The application process may be quicker. Since there’s no appraisal of collateral, the application process for unsecured loans is generally less involved.
Unsecured credit is widely available in various forms. Credit cards, personal loans, student loans and medical loans are all examples of unsecured loans.

Unsecured Debt the cons

Unsecured loans may be harder to obtain. Because of the risk, lenders are likely to have stricter credit requirements for unsecured loans than secured loans.
Unsecured loans almost always carry higher interest rates. Interest rates on mortgages, for example, are far lower than those on credit cards. Whereas 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 hard 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 spotty credit history and low credit score can restrict a borrower’s access to future credit and increase the costs of additional loans.

Secured Debt the pros

It’s generally easier to get a loan. Since lenders know they can repossess the security (collateral), if the borrower fails to pay, they are more willing to extend credit.
Costs for secured loans are generally lower. Again, because the lender doesn’t feel as exposed to the risk of loss, a borrower can usually get a secured loan at a lower interest rate.
There may be tax benefits. On some secured loans, such as mortgages, borrowers can take advantage of tax deductions for interest payments.

Secured Debt the cons

There’s a risk of losing the collateral. The borrower bears this risk and, in the case of an essential item such as a primary residence, the risk of losing the collateral is highly significant.
Secured loans may require additional insurance coverage on the collateral. For instance, mortgage borrowers have to have homeowner’s insurance. Auto lenders require that cars purchased with loans must be covered by comprehensive insurance policies. Insurance premiums add to the cost of the credit.
Loan uses are less flexible. The uses for the loan are generally tied to the collateral and therefore less flexible than unsecured loans.

How to prioritise debt repayment

Smart borrowers clearly consider whether a debt will be secured or unsecured before borrowing. But presence or absence of collateral also figures when deciding how to repay existing debts.

One recommended approach is to pay off the debt with the highest interest rate first. This is sometimes referred to as the debt avalanche method. Generally speaking, this often means concentrating on paying off unsecured debts before paying off secured debts.

The debt snowball method takes a different approach. With this method, you generally focus on paying off the smallest amount of debt first in a short period of time while still making payments on your other debts, to help generate momentum toward repayment.

Sometimes it’s better to prioritize needs. For instance, if you lose your job and have to choose between paying the mortgage and making extra payments on a credit card to reduce the high-interest balance, it may make more sense to pay the mortgage first. In the case of an either-or decision, ensuring you have shelter takes precedence.

Similarly, if you need your car to get to work, you may elect to make sure the car payment is made before the personal loan payment, even if the personal loan carries a higher interest rate.

If you find you need help paying your secured or unsecured debts then you should seek debt advice from a debt advisor or financial advisor. They can help you get your finances in order and make the best choice when it comes to debt relief.

Why does this matter?

The major lesson here is that you should be aware of the difference between secured and unsecured debt, and keep in mind that you typically have more to lose with secured debt. This means that secured debt should generally be the top priority in your repayment strategy.

Get free debt advice today

If you are struggling to pay off your debt then you can get free debt advice from IVA Advice. While many people may be wary of asking for help, it’s important to take responsibility for your situation. We will offer you a plan that deals with all aspects of your financial situation, including debt advice. If you feel like there’s nothing you can do to deal with your debts, and you want debt advice on writing them off and doing monthly payments, then contact IVA Advice. We can help you with a debt solution, debt management plans or IVA proposal. We’ll help you to prepare a budget and work out what options there are to deal with your debts. Call IVA Advice and chat with us, so we can understand the best way to help you.