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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?
Here are some other examples of unsecured debts:
- Credit cards
- Personal loans
- Medical bills
- Student loans
What is secured debt?
Common examples of secured debts include:
- Car, motorcycle, boat and RV loans
- Home equity loans and home equity lines of credit
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.