Navigating the world of personal debt can be tricky, so it’s important to understand a few basics when deciding what type of loan you need. Loans generally fall into two categories: secured and unsecured debt. The main difference between the two is that secured debt is secured by collateral, while unsecured debt is not.
What Is Secured Debt?
Secured debt requires that you put up an asset as collateral for the loan. An asset can be a car, a home, or even cash. If you do not pay the loan back, the lender can seize the asset in order to retrieve their funds. The asset is the lender’s security that the loan will be paid back, giving them less risk in the deal.
The most common examples of secured debt are auto loans and home mortgage loans. When you go to a dealership to purchase a car, the financing you obtain is secured with the car. If you don’t pay the loan, the lender can repossess the car to sell it and retrieve their cash.
Similarly, when you purchase a home, your mortgage loan is secured by the home. If you default, the lender can seize the home, sell it, and get some or all of their money back.
Secured loans, however, don’t have to involve a purchase. For example, if you own a car with a free and clear title, you may be able to get a personal loan for other purposes by using your car as collateral. The lender will hold the title until you pay the loan back.
A home equity loan works the same way. If you own a home and have equity in your home, you can use that equity as collateral for a loan.
What Is Unsecured Debt?
Unsecured debt, in contrast, requires no collateral. The lender provides the loan solely based on their assessment of your ability to repay the loan, which includes considering factors like your credit history and income. If you don’t repay the loan, the lender has to sue you for repayment because they have no asset as security.
An unsecured loan can simply be a lump sump personal loan, but credit cards also usually fall into the category of unsecured debt.
Unsecured debt is riskier for lenders, so it usually comes with higher interest rates and more strict qualification requirements.
Qualifying for Secured Debt
Qualifying for secured debt is generally easier than for unsecured debt since the lender carries less risk. For example, if you have a lower credit score , even under 600, in some cases it may be possible to get a Federal Housing Administration (FHA) mortgage loan to purchase a home. It may also be possible to get an auto loan.
Income requirements will apply also, although, again, they may be more lenient than those for unsecured debt. The lender will need to verify that you have enough income to make payments on the debt. They will assess your debt-to-income ratio (DTI), which is the amount you pay on debts compared to your income. For example, if you earn $6,000/month and have $1,800 in monthly debt payments, your DTI is 30%. The lower your DTI, the better.
The asset you are providing as collateral also needs to be worth more than the amount of the loan you’re obtaining. For example, if you are getting a personal loan for $5000 using a car as collateral, the car has to be valued at more than $5000.
It’s important to note that even though it’s easier to qualify for secured debt than unsecured debt, your creditworthiness can still affect the interest rate the lender charges. If you have a lower credit score and a higher DTI, your rate will likely be on the higher end of the interest rate spectrum.
Qualifying for Unsecured Debt
Unsecured debt comes with stricter requirements. You’ll generally need a higher credit score, strong income, and a lower DTI in most cases. A credit score of around 660 or above may give you a good chance of qualifying for unsecured debt as long as your income and DTI are also good.
However, interest rates are an important factor when getting an unsecured loan. They will generally be higher for unsecured than secured debt and will also be affected by your creditworthiness. For example, if a lender’s credit score range for unsecured debt is 660 and above, if you are on the low end of that range, you’ll probably pay a higher rate than someone with a credit score in the 700s.
In some cases, you may be able to get unsecured debt with a credit score under 660, but your interest rate may be extremely high. Maximum interest rates that lenders can charge can vary based on the state, type of lender, type of loan, and other factors.
Pros and Cons of Secured Debt
Secured debt has many advantages, but there are cons as well, so you should consider both when deciding what kind of loan to obtain.
Pros of Secured Debt
- Generally lower interest rates due to the lender taking on less risk.
- Easier qualification, again, due to the lender taking on less risk.
- Higher loan amounts may be available depending on the value of the collateral.
- Longer repayment periods than some types of unsecured debt (i.e. 30-year mortgage loans).
Cons of Secured Debt
- Risk of losing the asset if you can’t repay the loan (i.e. foreclosure or repossession).
- Upfront costs are possible for things like appraising and securing the asset.
- If the collateral depreciates in value, you could lose it and still owe money to the lender.
Pros and Cons of Unsecured Debt
Unsecured debt also has pros and cons.
Pros of Unsecured Debt
- No collateral is required so you’re not risking a specific asset like a home or car.
- Faster approval since there is no collateral to appraise.
- Flexible use of funds, meaning there is no specific purchase involved like a car or home.
- Can help build your credit.
Cons of Unsecured Debt
- Higher interest rates depending on your creditworthiness.
- Stricter qualification requirements.
- Generally lower loan amounts are available since there is no collateral.
- You can be sued if you fail to pay back the loan.
Secured Vs. Unsecured Debt – Which Is Right for You?
What type of debt you need depends in part on the purpose of the loan. If you are buying a home or a car, secured debt is likely your only option. If you need a personal loan for a reason like home improvement or to pay bills, whether secured or unsecured debt is better depends on a few factors.
Secured debt is probably your best option if:
- You need to borrow a large amount.
- You want a lower interest rate.
- You have an asset that has enough value to secure the debt.
- You’re confident you can make the payments consistently so that you won’t lose the asset.
Unsecured debt may be a better option if:
- You don’t want to risk an asset.
- You need a relatively small or short-term loan.
- You have strong enough credit to get a reasonable interest rate.
In Closing
Secured debt and unsecured debt have some key differences that are important to understand. Be sure to weigh the pros and cons before making a decision. Debt of any kind can affect your credit, either positively or negatively, so arm yourself with information so that you make the right choice for your financial health.
