There are generally two categories of debt: secured and unsecured. The primary difference between unsecured debt and secured debt is collateral. Secured debts are backed by collateral, while unsecured debts are not backed by collateral.
What is Unsecured Debt?
Unsecured debt is the result of the extension of credit that is not backed by collateral. Lending your friend cash for a drink is an example of unsecured debt because the repayment of that loan is based solely on your friend’s promise and trustworthiness.
Likewise, the outstanding balance on a credit card is unsecured debt. When a credit card company issues you a credit card, they typically do not require collateral. Instead, they consider your creditworthiness by looking at your credit score, and they charge an interest rate to justify the risk.
When a borrower defaults on unsecured debt, there is no asset for the lender to acquire as repayment. Therefore, the lender must sue to collect payment. Borrowers might be able to avoid repayment altogether if they declare bankruptcy, but this will destroy their credit score and make it very difficult to secure credit in the future.
Obtaining an unsecured loan from a bank typically requires an outstanding credit score and a competitive debt-to-income ratio. Unsecured bank loans often come with relatively high interest rates and are given to only the most creditworthy borrowers.
What is Secured Debt?
Secured debt is the result of an extension of credit that is backed by collateral. The borrower must put up an asset as surety for credit. Lending your friend cash for a drink on the condition that you hold onto their watch until their debt is repaid is an example of secured debt. You don’t necessarily have to trust your friend because you can pawn their watch if they fail to pay you back.
Mortgage and auto loans are common forms of secured debt. The collateral for these loans is the very asset that is being financed—the home or car. When a borrower fails to pay, the loan issuer will eventually seize the asset and sell it to compensate for the unpaid loan.
Secured debt financing typically comes with lower interest rates and is easier to obtain because the risk of default, called the counterparty risk, is relatively low since the borrower stands to lose an asset if their debt goes unpaid.
Since the security of secured loans is based on an asset, the loan issuer has an interest in the borrower maintaining the value of that asset. For this reason, lenders will often require that borrowers take out insurance on a house or car so that the collateral won’t become worthless in the event of an accident.
Prioritizing Debt Repayment
Two approaches are often recommended for prioritizing debt repayment. One, called the avalanche method, involves paying off debts with the highest interest rates first (typically unsecured debt). The other, called the snowball method, emphasizes quickly paying off the smallest debts first to create momentum.
However, you need a roof over your head and a vehicle to get to work, so paying your secured debts may take precedence over high interest credit card debt.
You can find help managing your secured and unsecured debts through consumer credit and debt relief solutions offered by companies like Americor. Contact a certified debt consultant today to receive a free debt analysis.