Learn the difference between secured vs unsecured debt, what they are, and how they work with a borrower’s loan.
The financial world can be confusing to navigate with all its terminology, and it’s easy to get lost. However, if you’re in the market for a loan, you’ll need to understand the difference between a secured vs unsecured loan to fully grasp the terms of your debt agreement. The primary distinction between these debt types involves collateral, assets, property, and whether the lender has recourse.
So, what is a secured or unsecured loan, and how does a secured loan work compared to an unsecured one? Let’s get into it.
What is an Unsecured Loan?
An unsecured loan is a type of loan that isn’t backed or secured by collateral or an asset the lender can claim in case of default.
Loan collateral is a physical or financial asset, like a car, home, or investment, that the borrower can use to secure loan funds with a lender. If a form of collateral is tied to a loan, then the lender might possibly seize that asset to pay off the loan if the borrower can’t repay and defaults. If a form of collateral is not associated with the loan, like with an unsecured loan, then the lender might not seize a specific asset if the borrower can’t repay.
Borrowers may prefer an unsecured loan for the peace of mind of not having to tie personal property or assets to the loan. On the other hand, unsecured loans are often associated with stricter credit requirements and higher interest rates to protect the lender from the higher risk of an unsecured debt, so they may be harder to qualify for.
How Does an Unsecured Loan Work?
In general, an unsecured loan works by considering things like creditworthiness rather than collateral security to approve a loan. What qualifies you for this type of loan can vary from lender to lender, but generally speaking, many lenders will consider the following to determine a borrower’s eligibility:
- Proof of Income: You’ll need proof of a steady, consistent source of income so the lender knows you have the means to repay your loan.
- Credit History: Good to excellent credit is often very helpful in getting an unsecured loan. This helps demonstrate how responsible you are with debt.
- Debt-to-Income (DTI) Ratio: As a rule of thumb, 35% or less of your money should go to debt repayment relative to your income. The lower the debt compared to your income, the more favorable your chances will be when it comes to getting a loan.
This information helps demonstrate to lenders that you have the ability to make loan payments and that you are responsible with your usage of debt. Work to build credit so you can get the best rates and terms when applying for financing.
Unsecured Debt Examples
Some examples of unsecured debts can include any kind of debt that isn’t attached to an asset of some kind. This could include credit cards, medical bills, personal loans, student loans, or utility bills.
- Unsecured credit card
- Medical bills
- Unsecured personal loan
- Student loans
- Utility bills
Unsecured Credit Cards
When an issuer approves you for an unsecured credit card, they extend a line of credit based on your creditworthiness, representing the maximum amount you can borrow. While secured credit cards require a security deposit, unsecured credit cards have no collateral requirement, instead the lender relies on your promise to repay as you use the credit limit available on the card.
Medical Bills
Patients receive medical services or treatments without having to provide collateral as security for the debt. Instead, the health provider will send you or your insurance company an itemized bill afterward detailing the services rendered and the associated costs. You’re then responsible for paying the bill out of your own pocket or through your health insurance if you have it.
Unsecured Personal Loan
Unsecured personal loans can be used for many purposes, like debt consolidation, home renovations, medical expenses, large-ticket purchases like appliances, and more. Although lenders may have their own use restrictions for how their personal loan can be used, they often don’t require a form of collateral to apply.
Student Loans
Student debt is a common unsecured debt that helps more people afford higher education. No collateral is required to get this type of loan and attend school. In addition, for most student loans, payments aren’t due for up to six months after graduation. Rather than relying on an asset to secure the loan, student loans instead rely on the student’s promise to repay.
Utility Bills
Utility bills, including electricity, water, and gas, are considered unsecured debts. Unpaid utility bills can show up on your credit report and negatively impact your score if the utility company reports you to the credit bureaus. Lenders will consider these delinquent accounts when evaluating your creditworthiness, so make sure to always pay your bills on time.
What is a Secured Loan?
A secured loan is a type of loan that is backed or secured by collateral or an asset the lender can claim in case of default.
If you have less-than-perfect credit, you may prefer a form of secured debt because it’s easier to qualify for and tends to be associated with lower interest rates. However, secured debts can also pose a higher risk for your property if you can’t make payments, so you’ll want to make sure you can take on these payments.
How Does a Secured Loan Work?
During the lending process, the lender will offer you a loan amount up to a specific percentage of the appraised collateral value, referred to as the loan-to-value (LTV) ratio.
If a borrower is unable to make payments on a secured debt, the lender may have a legal right to seize the property tied to the secured loan. This can involve repossession or foreclosure, depending on the collateral.
Secured Debt Examples
Secured debts can include any debt attached to an asset. Examples range from mortgages, title loans, and home equity loans to secured credit cards and pawnshop loans.
- Mortgages
- Title Loans
- Home Equity Loans
- Secured Credit Cards
- Pawnshop Loans
Mortgages
Mortgages require the borrower to provide collateral. In the case of a mortgage, the collateral you’re providing is the home you’re purchasing. If you don’t repay the loan according to the terms, the lender can legally foreclose on the property and sell it to recoup the debt. This collateralization reduces the lender's risk and results in lower rates than unsecured loans.
Title Loans
When you take out a title loan, you provide the lender with the vehicle’s title as security. This loan allows you to use the value of your car to get the money you need now. But if you default on this type of loan, the lender may repossess the car and sell it to recover the debt you owe.
Home Equity Loans
The difference between the market value of a home and its outstanding mortgage balance is known as equity, which will serve as collateral for your home equity loan. When acquiring a home equity loan, the lender places a lien on your property so they can foreclose on it if you default.
Secured Credit Cards
Secured credit cards use cash deposits as collateral. When you open a secured credit card, you deposit a certain amount of money with the card issuer, typically ranging from a few hundred to a few thousand dollars. This deposit acts as security for the card. In default, the issuer can use this deposit to cover the outstanding balance.
Pawnshop Loans
Pawn shop loans involve providing a valuable item as collateral, like electronics or jewelry, in exchange for a loan. The pawn shop appraises your asset and bases the loan amount on the item’s value, which they can keep and sell if you don’t repay them.
Secured vs Unsecured Debts
The difference between secured debt vs unsecured debt is that secured debts are attached to an asset or form of collateral, while unsecured debts are not attached to an asset or form of collateral. There are a few other key differences that are important to understand as well.
For example, unsecured debts are not tied to collateral and are thus a higher-risk loan for the lender to offer. They also often come with higher credit score requirements and higher interest rates to help the lender offset that higher risk. Alternatively, a secured debt is tied to collateral and is thus a higher-risk loan for the borrower. They also often come with lower credit score requirements and interest rates since the collateral helps offset much of the risk for the lender.
Credit Score Criteria
Unsecured debts rely entirely on your creditworthiness and promise to repay the loan, which is why lenders typically have stricter credit score requirements. Because they aren’t backed by collateral, the creditor could have their own financial criteria, requiring a credit pull and a high score before they approve the loan. Credit history, for example, is an important factor, as a more extensive credit history proves that you’ve managed your debt responsibly in the long term.
For secured debts, however, lenders are less concerned about credit. The collateral reduces the lender’s risk, which means your credit is less likely to disqualify you from this type of loan.
Collateral Requirements
Because secured debts are backed by collateral, the creditor could have unique asset or property requirements. For example, if you are taking out a car loan to pay for your car, the lender may require you to have a certain type of insurance. Or, if you’re taking out a title loan, the lender may require you to bring in your car for an inspection before they approve the loan.
In an unsecured debt scenario, lenders may initiate legal action to collect unpaid debts without collateral to seize.
Financing Terms
Secured loans generally offer longer repayment terms, higher loan amounts, and lower interest rates because the required collateral makes them less risky. In contrast, unsecured loans have shorter repayment terms, lower loan amounts, and higher interest rates since they rely primarily on creditworthiness.
Are Payday Loans Secured or Unsecured?
Payday loans are a type of unsecured loan with a shorter term that helps borrowers afford purchases until their next paycheck, which they’ll use to repay the loan. Since payday loans are unsecured loans, that means no collateral is required to get approved. However, the lender may charge higher interest rates to lower the risk. The approval process is usually fast, but the loan is due in full within two to four weeks from the borrower’s upcoming paycheck or other form of income.
Are Personal Loans Secured or Unsecured?
Personal loans are a type of unsecured loan with various uses, from college tuition to debt consolidation. Unsecured personal loans don’t need any collateral, relying instead on financial history, creditworthiness, and income. Secured personal loans that use collateral like your savings account may also be available depending on what the lender provides.
Which Debt Should You Pay Off First?
Debt and credit can be useful financial tools when used responsibly. But between secured debts and unsecured debts, which type of debt should you prioritize paying off first?
Ultimately, the answer to this question comes down to your financial situation. If you have delinquent accounts in collections, start by paying those off first. They can hurt your credit and long-term ability to acquire new debt. Various types of debt delinquency can carry more severe penalties than others. For example, the lender may proceed with foreclosure if you’re behind on your mortgage.
If you don’t have delinquent debts, your next focus should be paying off any secured debts you might have since those debts come with the risk of your assets being seized.
Next, you should focus on paying off unsecured debts since they can come with higher interest rates and cause your overall balance to compound faster. Paying off unsecured debts sooner can save you money over time on interest charges.
You might even consider the interest behind any debts you have as a deciding factor for which debt to pay off first. Paying off high-interest debt first can be a smart way to ultimately save the most in the long run.
Whatever debt repayment method you choose, make sure you keep your personal financial situation in mind and make the best choice for you and your finances.
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