Loans and other types of financing available to consumers generally fall into two main categories: secured and unsecured debt. The main difference between the two is the presence or absence of collateral to protect the lender if the borrower defaults.
Key Takeaways
Secured debt is debt in which the borrower provides some asset as collateral for the loan. Secured loans reduce the risk for the lender. Unsecured debt has no collateral. Lenders issue funds in unsecured loans based solely on the borrower's creditworthiness and promise to repay. Because secured debt is less risky for lenders, its interest rates are generally lower.
Investopedia / Jessica Oller
What is a secured debt?
A secured debt is debt in which the borrower provides some asset as collateral for the loan. Secured debt means that if a default occurs, the lender can seize the asset to recover the funds lent to the borrower.
Common secured debt obligations for consumers are mortgages and auto loans, where the item being financed serves as collateral for the loan. In the case of an auto loan, if the borrower doesn't make payments on time, the loan issuer can eventually take ownership of the vehicle. When an individual or business takes out a mortgage, the property in question is used as collateral for the repayment terms. In effect, the lending institution holds equity (a financial interest) in the property until the mortgage is paid in full. If the borrower defaults on payments, the lending institution can seize and sell the property to recoup the amount the borrower owes, or at least a portion of it.
A home equity loan or home equity line of credit (HELOC) is another type of secured debt secured by the borrower's home. Homeowners with enough equity can take out both a traditional mortgage and a home equity loan or HELOC at the same time on the same property.
Similarly, businesses can take out secured loans using real estate, capital equipment, inventory, invoices, cash, etc. as collateral.
Because they're lower risk, secured loans generally have less stringent credit requirements than unsecured loans. For example, a credit score of 620 is generally considered good enough to get a conventional mortgage, while government-backed Federal Housing Administration (FHA) loans have an even lower cutoff, set at 500. However, just like with unsecured loans, a higher score can mean a lower interest rate or a higher amount you can borrow.
The main difference between secured and unsecured debt is the presence or absence of collateral (something used as security against default on the loan).
What is unsecured debt?
Unsecured debt has no collateral. As the name suggests, no collateral is required. If the borrower defaults on this type of debt, the lender must file a lawsuit to try to collect the debt.
Lenders issue unsecured loans based solely on the borrower's creditworthiness and promise to repay. Therefore, banks typically charge higher interest rates on these so-called signature loans. These types of loans also usually have stricter credit score and debt-to-income ratio requirements, making the loans available only to the most attractive borrowers. While some personal loans are available to those with lower scores, a credit score of 670 or higher is usually required to qualify for a wide range of favorable personal loans.
However, if you can meet the strict requirements, you could potentially qualify for the best personal loan available.
Outside of loans from banks, examples of unsecured debt include medical bills, certain retail installment contracts like gym memberships, and outstanding balances on most credit cards. When you get a credit card, the credit card company essentially issues you a line of credit without requiring any collateral. But to justify the risk, they charge a high interest rate on the money you borrow.
Unsecured debt securities, such as bonds, involve a higher level of risk than secured debt, which are asset-backed obligations, because they are backed solely by the credibility and credit of the issuer. Because the risk to the lender is higher compared to secured debt, interest rates on unsecured debt tend to be correspondingly higher.
Unsecured government debt is a special case. For example, Treasury bills (T-bills) issued by the U.S. government, although unsecured, have lower interest rates than many other types of debt. This is because the government has the power to print additional dollars or levy taxes to repay the debt, so this type of debt instrument has virtually no risk of default.
The benefits of secured vs. unsecured debt
We've explained each type of debt above, but let's get more specific about the benefits of each.
Benefits of Secured Debt
The advantages of secured debt are:
Having collateral, such as real estate or a valuable asset, gives lenders more security, which means the interest rate you can get will probably be lower. Because interest rates are probably lower, monthly payments may be slightly lower with secured debt. Secured loans are often easier to obtain, especially for people with low credit scores or limited credit history, because the collateral assets help back up the likelihood of future debt payments. Secured debt may come with longer payment terms. Lenders may be willing to accept these longer terms because of the collateral assets, which means people can have a little less pressure on their monthly cash flow.
Benefits of Unsecured Debt
The advantages of unsecured debt are:
Unsecured loans don't require collateral, so there's no risk of losing a specific asset in the event of default. Not needing collateral simplifies the application process and can speed up approval, since proof of a secured asset isn't required. Unsecured loans typically give borrowers the freedom to use the funds as they need them, whereas secured loans may be tied to an underlying asset (i.e. a car loan must be used to purchase a car, which is the secured asset).
Unsecured loans with favorable terms
In some cases, well-qualified borrowers may be offered unsecured loans with favorable terms similar to those of secured loans.
In this case, the lender evaluates the borrower's credit history, income, reputation, and financial situation as the basis for the loan. However, unlike secured loans, no collateral is posted that is tied to a tangible asset such as a property or vehicle. The lender is still willing to grant favorable terms and interest rates based on the business or individual's reputation, stability, etc. Although this is an unsecured loan, the lender agrees to favorable terms (which often only apply to secured loans).
This scenario is particularly favorable for those seeking favorable loan terms without putting specific assets at risk, although this may be difficult to achieve as lenders will extend favorable loan terms without having collateral assets to reduce risk exposure.
Secured Credit Cards
Note that in some cases, a traditionally unsecured loan may become provisionally secured while the borrower builds credit or cultivates a relationship with the lender. One example is a secured credit card.
A secured credit card is a type of credit card that requires the cardholder to provide a cash deposit as collateral. If you haven't heard of this before, it's because most credit cards don't require collateral assets. When a credit card is issued, the credit limit is often equal to the amount of the deposit.
Managing this secured credit card well, making regular payments and keeping the balance low against the credit limit can have a positive impact on the cardholder's credit score, plus they may be issued more credit (no secured assets required) or they can surrender the secured assets and convert the card to an unsecured line of credit.
Secured and Unsecured Debt in Investments
Let's briefly touch on what secured and unsecured debt means from an investor's perspective: When you invest in bonds or debentures, you are either investing in secured or unsecured debt.
Investors who hold both secured and unsecured debt in their portfolios benefit from risk diversification by recognizing that unsecured debt is particularly riskier. Secured debt, backed by collateral, has a lower risk of default, but also a lower potential return because interest rates are often lower.
There are other things to keep in mind when it comes to investing. For example, as mentioned above, secured debt obligations can have long tenors, which means that secured debt obligations are more exposed to interest rate risk as interest rates can fluctuate more dramatically over the long term than they can in the short term.
Is secured or unsecured debt better?
From the lender's perspective, secured debt is advantageous because it poses less risk. From the borrower's perspective, secured debt carries the risk that they will have to forfeit the collateral if they are unable to repay. On the plus side, however, you are more likely to receive a lower interest rate than with unsecured debt.
Are personal loans secured or unsecured?
Personal loans are generally thought of as unsecured, but they can be secured with or without collateral. Examples of the types of assets that can be used as collateral for a secured personal loan include cars, boats, jewelry, stocks and bonds, life insurance policies, and savings in a bank account.
Which has a higher interest rate: secured or unsecured debt?
Unsecured debt is riskier because it is not backed by collateral assets, and it often charges borrowers higher interest rates.
Can I combine secured and unsecured debt?
Debt consolidation is the process of combining multiple debts into one, more manageable loan. By using a secured loan (such as a mortgage) to pay off high-interest unsecured debt, borrowers may be able to lower their overall interest costs and simplify repayments. Typically, people do this to simplify their debt portfolio as well as reduce the interest they pay.
Conclusion
Loans can be secured or unsecured. A secured loan requires some sort of collateral, such as a car, house, or other valuable asset that the lender can seize if the borrower does not repay the loan. An unsecured loan does not require collateral, but does require the borrower to be of sufficient creditworthiness to the lender. Secured loans generally have lower interest rates than unsecured loans because they are perceived as less risky.