When you use a credit card or borrow money with a loan, you’re taking on debt. There are actually two main types of debt: secured and unsecured. Understanding the difference between them can help you make the right choice for your situation.
Here’s what we’re going to cover:
- What’s the difference between secured debt and unsecured debt?
- How does collateral work?
- Examples of secured debt
- Benefits of secured debt
- Oportun: Affordable secured loans, no credit history required
Key takeaways:
- The difference between secured debt and unsecured debt is the requirement for collateral. Secured debt requires collateral. Unsecured debt does not.
- Collateral is something of value that you agree to give your lender if you don’t make your debt payments on time, for example your car when you take out a car loan, or your house when you take out a home loan. If you don’t pay back your loan, the lender can keep your collateral or sell it to regain the value of your missed payments.
- Secured debt is usually easier to qualify for than unsecured debt. By applying for secured debt, you may be able to get larger loan amounts and lower interest rates.
What’s the difference between secured debt and unsecured debt?
There is one basic difference between secured and unsecured debt. Secured debt requires collateral. Unsecured debt does not.
How does collateral work?
With secured debt, your lender has the legal right to take your collateral if you don’t make your debt payments on time. The lender can then sell your collateral to get back the value of your missed payments. This arrangement gives your lender additional financial security.
What can be used as collateral?
Lenders have different requirements about what assets can be used for collateral. Generally, your collateral must be something that can be easily sold for cash. It must be worth at least as much as the amount of money you’re borrowing.
Types of collateral include:
- Real estate
- Vehicles
- Precious metals
- High-end collectibles
- Bank accounts
- Investments
- Insurance policies
In some cases, your lender may require you to have insurance for your collateral. For example, if you use your home as collateral for a mortgage, you may need to show proof of home insurance. This helps protect the value of your collateral.
Why do lenders require collateral?
Collateral reduces a lender’s risk. When you put up collateral for a secured debt, you know that you could lose a valuable asset if you don’t make payments on time. This makes lenders more inclined to trust that you will pay back what you borrow.
If your debt is unsecured, meaning that there is no collateral, lenders have only your creditworthiness to rely on. They determine this in part by looking at your credit score.
What is a credit score?
Your credit score is a number between 300 and 850 that gives businesses an idea of how likely you are to make payments on time, based on your past financial behavior.
If you have a credit score of 670 or higher on the FICO scale, lenders will generally view you as a creditworthy borrower. A high credit score shows that you’ve managed credit responsibly in the past. This makes lenders feel safer about approving your loan or credit card application.
If you have a low credit score, lenders may hesitate to approve your application. Your credit history might show that you’ve struggled to make debt payments on time in the past. In this case, a lender may require collateral for your debt.
Examples of secured debt
Whether you take out secured or unsecured debt may depend on your reason for borrowing money, or the amount you wish to borrow. Here are some common examples of secured debt.
Mortgages
When you take out a mortgage to buy a home, your home is the collateral for that loan. Until you make your final mortgage payment, your lender has the right to repossess your home if you miss payments. This repossession is known as foreclosure.
Auto loans
If you take out an auto loan to buy a car, the car you purchase is the collateral. Up until you make the final payment, your car still belongs to the lender. They have the right to repossess it if you miss payments.
Secured personal loans
Most personal loans don’t require collateral. The ones that do are known as secured personal loans. Each lender will have their own requirements about the type of collateral you need for a secured personal loan.
Secured credit cards
Most credit cards are unsecured, meaning they don’t require any collateral. Secured credit cards typically require a security deposit in cash. If you miss payments on your secured credit card, your lender can take the money from this security deposit.
Benefits of secured debt
Before taking on secured debt, be sure you understand that it comes with the risk of losing your collateral. But secured debt also offers advantages. Here are some possible benefits of secured debt.
Easier approval
Because collateral reduces the risk for lenders, secured debt is often easier to qualify for than unsecured debt.
Lower interest rates
You may also qualify for a lower interest rate on secured debt than you’d get with unsecured debt. When a lender’s risk is lower, they don’t need to charge as much interest to protect themselves from financial loss.
What are interest and interest rates?
The interest rate is a percentage of your total loan amount or credit card balance. It determines how much interest you must pay your lender to borrow money. This is in addition to paying back the loan or credit card balance.
Larger loan amounts
If you want to borrow a large amount of money, you typically have to put up collateral to protect the lender from financial loss. Most mortgages and auto loans fall into the category of secured debt.
Improved credit history
If you have a low credit score or no credit history, you may find it hard to qualify for unsecured debt. Secured debt can help you start improving your credit history right away, as long as you make all your payments on time. After you’ve increased your credit score, it may be easier for you to qualify for unsecured debt.
Oportun: Affordable lending options designed with you in mind
Now that you understand what secured debt is, you can learn about how Oportun may be able to help you if you’re looking for affordable credit options. Visit our homepage to learn about:
- Personal loans
- Secured personal loans
- Credit cards
- Saving
- Investing
- And more!
Sources:
Experian. What is collateral?
Experian. What is a good credit score?
Consumer Financial Protection Bureau. How does foreclosure work?
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