How well do you understand the differences between secured and unsecured debt? And how much does it really matter in practical terms? For those who know for certain that they can pay off their debt on time, the distinction may not feel like it matters quite as much.
But if you’re afraid you may slip behind on payments, you’ll feel the contrast in a big way. It can be the difference between collection calls and watching your car get towed away.
Here’s what you need to know about a secured loan vs. an unsecured loan.
Secured debt vs. unsecured debt at a glance
Note, while some types of secured debt are more accessible to applicants with less-than-stellar credit, that’s not always the case. For example, many mortgage lenders look for a credit score of at least 620 before approving applicants for conventional home loans.
What is secured debt?
Put simply, secured debt is backed by collateral. Depending on the specific loan, you can use anything from jewelry to your car to a sum of money to your house as collateral. If you stop making payments on a secured loan, the lender can eventually take your collateral and sell it to repay what you owe.
Examples of secured debt include:
- Mortgages, home equity loans, and home equity lines of credit (backed by your property)
- Auto loans (backed by your vehicle)
- Secured credit cards (backed by a security deposit)
- Pawn loans and title loans (backed by a specific valuable item)
Secured loans typically are more accessible to those with thin or poor credit, and they come with lower APR than unsecured loans. That’s because the bank assumes less risk; it knows it can recoup value if you default on your loan by seizing your collateral.
Even if you’re current on all other debts, a lender can seize your collateral if your secured account becomes delinquent. In other words, you should consider your essential secured debts (especially home and auto) as a priority so that you don’t lose assets.
What is unsecured debt?
Conversely, unsecured debt is not backed by collateral. Common examples of unsecured debt include:
- Credit cards
- Personal loans
- Medical bills
- Most student loans (federal and many private)
Lenders rely more heavily on your credit score, income, and other credit-related factors than secured loans; put simply, they have less recourse to recover what you owe on unsecured debt, because they have no agreed-upon asset to take if the account becomes delinquent. Thus, vetting will typically be stricter to ensure you’re a responsible borrower.
Pros and cons of secured debt
Pros
- Lower interest rates and monthly payments in general compared with unsecured options
- Potentially higher borrowing limits
- May be easier for those with thin credit files to qualify for
Cons
- Risk of losing the collateral if you fall behind
- Products like HELOCs and title loans can put essential assets on the line for nonessential spending
- Fees and closing costs can be higher on large secured loans
Pros and cons of unsecured debt
Pros
- Doesn’t put assets at risk of repossession
- Often faster to get approved and funded for those with good credit
- Good for smaller, short-term needs if you can pay off quickly
Cons
- Typically higher interest rates
- Delinquencies can still lead to collections, lawsuits, and wage garnishment
- More difficult to be approved if you have limited or bad credit
When to choose secured vs. unsecured borrowing
Secured debt can make sense for some of those “milestone” purchases in life; in fact, they’re often mandatory unless you pay entirely with cash. For example, a mortgage and an auto loan are both backed by collateral (your home or car, respectively). They come with lower rates and higher loan amounts.
Unsecured debt is oftentimes better for those with fair or better credit scores looking to make smaller purchases that can be paid off quickly. You typically don’t want to take out secured debt for purchases that aren’t essential, as you’re exposing yourself to unnecessary risk.
All to say, neither secured nor unsecured is intrinsically “better.” They’re just used in different situations, such as the purpose of the loan, your budget, your credit profile, and how much risk you’re willing to accept.
What happens if you default
Again, the repercussions of defaulting on a loan look different depending on whether your debt is secured or unsecured. Either one can leave deep negative marks on your credit—and your overall financial health.
Secured: repossession and foreclosure
If you allow a secured loan to become delinquent, you’ll usually receive notices from your lender that gives you a window to bring your account current before they take more extreme measures. If you don’t comply, the lender can take your property and sell it to recover its losses. In the event of a home loan, it can foreclose on your property.
And if selling your assets can’t fully cover what you owe, the lender may still require you to repay the remaining balance.
Unsecured: collections, judgments, and garnishment
Unsecured debt isn’t quite as scary, but it’s still no walk in the park. Because there’s no collateral to seize, the lender may charge off your debt (write it off as a loss) and sell it to a third-party collection agency. If you still can’t repay the debt, the collection agency may file a lawsuit. This can result in wage garnishment or a bank levy if they win.
How secured and unsecured debt affect your credit score
Your credit score doesn’t discriminate between secured or unsecured debt. Both have the same effect on your score. Big missteps with either can leave a black mark on your credit for a long time; things like charge-offs and foreclosures can remain on your credit report for up to seven years—making it hard for you to qualify for other loans.
The single biggest factor that affects your credit score is your payment history. As long as you make at least the minimum payment each month, your credit score won’t be affected. However, your credit score will be affected differently based on whether you’re opening revolving credit or an installment loan. That’s because of the way your credit utilization is calculated. Credit utilization is the amount of your current revolving credit limit that you’re currently using. It’s the second most impactful factor of your credit score, only behind payment history.
Installment loans, such as mortgages, auto loans, and personal loans, don’t count against your credit utilization. Revolving credit, such as credit cards, do. The more of your available revolving credit you use, the worse for your credit score.
The takeaway
Here’s the big difference between secured and unsecured loans:
- Secured loans require collateral. They’re often easier to gain approval with a less-than-stellar credit score, and their interest rates tend to be lower.
- Unsecured loans don’t require collateral, but rates tend to be higher because the lender is assuming more risk.
If you default on a secured loan, the lender can take your assets and liquidate them to help repay what you owe. If you default on an unsecured loan, you may be taken to court and have your wages garnished or your bank account levied.
Whichever option is best for you, it’s important to compare loan terms, such as repayment timeline and APR, and avoid borrowing more than you can repay each month.
Frequently asked questions
Is a credit card secured or unsecured debt?
A credit card can be both secured or unsecured, depending on the one you open. If you open a secured credit card, you’ll have to submit a security deposit; your credit limit will typically mirror the size of that deposit.
Can unsecured debt become secured?
It’s possible for unsecured debt to become secured. If your account becomes delinquent, the creditor may sue you and be allowed to place a lien on your property.
Which is easier to discharge in bankruptcy — secured or unsecured?
Unsecured debt is generally easier to discharge in bankruptcy.
Do secured debts always have lower interest rates?
Secured debts don’t always have lower interest rates, but they commonly do. It’s possible for the most creditworthy borrowers to get an unsecured loan with an APR that’s lower than someone with fair credit who opens a secured loan.
Are student loans secured or unsecured?
Student loans are unsecured debt.
