Differences Between Secured and Unsecured Debts and Loans

Debt comes in many forms, from credit card debt to student loans, medical debt and more. It can be categorized based on how it impacts your net worth (good debt or bad debt) and how it affects your credit score. But the most important differentiator is whether the debt is secured or unsecured.

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In this guide, we’ll discuss the differences between these two forms of credit and look at the ways that collateral can impact student loans and credit card debt.

Differences Between Secured and Unsecured Debts

There are many subtle differences between unsecured and secured debt, including how the debts are settled, what rights the debtors have, and more. But the main difference is that secured debts are tied to collateral while unsecured debts are not.

A home loan is the most common type of secured debt, with the house being used as collateral. If the homeowner fails to make payments and is unable to agree terms with the lender, then the home may be repossessed. As we discussed in our guide, What Score do you Need for a Mortgage? repossessions are very costly and are not something the lender will rush into. But if the debtor consistently fails to make payments, they’ll begin the process and cut their losses. 

Can Unsecured Debt Become Secured?

It is possible for unsecured debt to become secured, at which point you could lose assets. There is no collateral as such, but it’s possible for a judgment to be filed and for wages to be garnished or cash to be taken from bank accounts. 

This is not something that happens quickly or without your prior knowledge. If a debt collector is threatening to take cash or assets from you relating to an unsecured debt, there’s a good chance they’re being deceptive, in which case they may be breaking the law (see our guide to What a Debt Collector is Allowed to do). However, if you refuse to repay the debt and generally don’t give the collectors the time of day, they may sue you. 

The issue will be taken to the courts and a judgment will be filed against you, with the courts essentially turning the unsecured debt into secured debt.

This is rare, but it can happen and there’s no way of knowing when it will or won’t occur. It has been said that debt collectors won’t chase debts of less than $5,000 through the courts as they deem them to be insignificant and will simply write them off. However, while this process is costly and time-consuming, collection agencies buy debt very cheaply and there is still a profit to be made by dragging even the smallest debts through the courts.

Don’t assume you’re safe just because the debt is small and don’t ignore the debt collectors in the hope that everything will go away, because as soon as that unsecured debt becomes secured debt, your rights change drastically.

Secured and Unsecured Debts Personal Loans

Personal loans, just like credit card debt, can be both unsecured and secured. In both cases, you are given a lump-sum in exchange for meeting a minimum payment and adhering to the terms of the loan. However, the rights of the lender and the borrower differ considerably.

How Can you Apply for an Unsecured Loan?

You generally need a high credit score to apply for these debts, as the lender doesn’t have much recourse if you fail to pay. 

You can apply online and through your bank or credit union. But before you do, keep the following in mind:

  • Look for Alternatives: Do you really need a new credit card right now, can you handle any more credit card debt if it comes to that, and can your credit report take another hit? These are the questions you need to ask yourself before rushing into new credit card and personal loan applications.
  • Watch for Hard Inquiries: Every time you apply for a new credit card, you run the risk of receiving a hard inquiry, which can reduce your credit score by as much as 5 points. However, this can only happen with your consent; the lender needs your permission before they can initiate it.
  • Rate Shop, Where Possible: If you apply for multiple loans of the same type within a 14 to 45-day period (depending on the credit scoring system) those hard inquiries will merge into one. This is true for personal loans, home loans, and car loans. However, credit cards all count separately, and you need to be extra careful when applying for these.
  • Check the Terms: Don’t get distracted by reward schemes and grace periods—focus on interest rates, penalties, and annual fees. These are the things that really matter, because while a little credit card cashback might earn you a few extra bucks, even the slightest increase in interest can cost you thousands.
  • Create a Budget: Paying off debt is a long, drawn-out and difficult process, and it only gets longer if you keep adding new debt. It’s important to plan ahead, to make sure you don’t do anything that you’ll regret in the future, and to stay ahead of your payments. 

What are the Different Types of Unsecured Loans?

Unsecured debt covers everything from medical bills to credit card debt and more.
The most common unsecured debts include:

  • Credit Card Debt: The average US household has close to $10,000 worth of credit card debt. It’s not the biggest consumer debt issue in the United States, but it’s a growing problem nonetheless and one that has locked countless borrowers into a cycle of persistent debt.
  • Store Credit Card Debt: Just like traditional credit cards, store cards provide users with a chance to spend money they don’t have and only charge them when their balance rolls over at the end of the month. Unlike traditional cards, however, store cards charge much higher interest rates and annual fees and are often responsible for disproportionately high credit card debt.
  • Student Loan Debt: Some of the biggest personal loans that Americans have are tied to education. These loans average more than $20,000 per person and for students in medical school and law school, that number is well into the 6-figures.
  • Medical Debt: Although unsecured, medical debt is subject to some rules that you won’t find with credit card debt and other forms of unsecured debt. For instance, while credit card debt is at the back of a line for collection when a borrower dies, medical debt accumulated during the last 6-months of their life is at the very front.
  • Personal Loans: All personal loans not tied to assets are classed as unsecured. Personal loans may be provided for debt repayment reasons or to fund major purchases. 

How Can you Apply for a Secured Loan?

When you apply for a secured loan, you offer something as collateral, which means the lender has the right to take it from you if you default. Generally speaking, a secured loan will offer more favorable interest rates than an unsecured loan, but you’ll still be subject to a credit check, and in most cases, you’ll also need to pay an origination fee.

You can apply for a secured credit card through a bank, credit union, or alternative lender. You repay the loan by making a fixed monthly payment and if you default and refuse to negotiate with the lender, they may assume control of your asset. Secured loans include:

  • Mortgage: Also known as a home loan, a mortgage is a substantial loan used to purchase a house, which then serves as collateral. The average mortgage payment in the United States is a little over $1,000 a month and roughly 1 in every 200 fail to repay the loan and lose their collateral as a result.
  • Auto Loans: Car loans are secured against the purchased vehicle and result in around 1 repossession for every 172 loans, with the average vehicle costing over $30,000.
  • Home Equity Loans: These loans are taken out against a home, with the borrower cashing in some of the value and earning a lump sum in exchange. They will be asked to meet a monthly payment and can lose the house if they do not.
  • Pawnbroker Loans: A borrower can use possessions as collateral to acquire a sum of money from a pawnbroker. If they fail to repay the debt, that collateral will be sold. Common items used as collateral include jewelry, musical instruments, and collectibles. 

What Can be Used as Collateral on Personal Loans?

As mentioned above, you can use everything from a house to a car as collateral on loans. It all depends on the borrower and the type of debt but providing the collateral matches or exceeds the value of the loan, it can be used. 

Is it Smart to Take out a Personal Loan to Pay Off Debt?

Using personal loans to clear debt can be beneficial, but it’s not always easy to find a loan large enough or with favorable terms. This process is known as debt consolidation and while it can be performed by the borrower and on their terms, it’s generally more effective with the help of a debt consolidation company.

They will provide you with a debt consolidation loan that will then be used to clear all your debts, including credit card debt and personal loans. In exchange, they’ll provide you with a single, long-term loan that has a better interest rate and a lower monthly payment, but also has a longer term. This means that you save more money in the short term but pay much more over the lifetime of the loan.

If you have a lot of credit card debt, you can also use a balance transfer credit card. These cards generally provide higher interest rates, but they also offer a 0% APR introductory period of up to 18 months. All credit card debt can be moved to these cards by the lender, leaving the borrower with a single debt to focus on and an extended, interest-free period in which to repay it.

Secured vs Unsecured Debt After Death

In some states, known as Community Property States, a borrower’s debts can be passed onto their spouse. This is true for both unsecured debt and secured debt. In most states, however, unsecured debt will be discharged on death while secured debt will become the responsibility of the new asset owners.

We have written about this subject extensively in the past and you can read our guide to What Happens to Your Debt When You Die to learn more, but here is a quick summary:

Secured – Home Loans and Car Loans

If the house and car are passed onto an heir, they can assume control of the debt. The lender has the right to repossess the property, but due to the costs involved with this process, they will generally seek to negotiate with the new owner. The owner can also clear the balance and assume complete control of the asset or simply hand it back to the lender.

Unsecured – Tax Debt and Medical Debt

Upon death, the borrower’s estate will enter probate and all debtors will seek to claim what they are owed. This is true for all 50 states and for unsecured debts. All tax debt will be at the head of the queue, as will medical debt that was accumulated 6 months before death. Once these debts have been repaid then other lenders will get their share.

Only when these debts have cleared will the assets be passed to the heirs as instructed in the will.

Unsecured – Credit Card Debt and Personal Loans

Loans and credit card debt can be claimed from the decedent’s estate, but they’re at the back of the line—once everything’s gone there is nothing the lender or collector can do.

It’s worth noting, however, that collectors have been known to contact the decadent’s next of kin and insist they repay the credit card debt, even if they are not legally obligated to do so. They may claim that the spouse/heir is morally obligated, or they may simply resort to deception, taking advantage of their grief and unfamiliarity. If your loved one has recently died and you’re being chased by creditors, tell them to leave you alone (or ignore them) until you have time to assess the situation and don’t rush into making any payments or commitments.

Unsecured – Student Loan Debt

Student loan debt is the most forgiving as all federal student loan debt is discharged on death. The same is true for major private lenders, but this rule doesn’t apply to everyone. Your lender may seek to claim the money from your estate on your death.

Are There Any Exceptions?

If you reside in one of the nine Community Property States (Arizona, Idaho, Nevada, Louisiana, Texas, Wisconsin, California, New Mexico, Washington) you will become responsible for your spouse’s debts when they die. Assuming, that is, the debt was acquired during the marriage and not before.

If you co-signed on the credit card or personal loans, you will also become responsible for it. However, where federal student loans are concerned, they will still be discharged. This is true even if you’re the student and your cosigner dies. There are also similar rules in place for many private loans, but it all depends on the lender.

Other Secured and Unsecured Borrowing

If you have a poor credit score and a high debt-to-income ratio, you may struggle to get a credit card. Most lenders will turn you away with a credit score of less than 580 and the ones that do accept will offer you cards with higher interest rates.

It’s an endless cycle, because the worse your credit score is, the fewer options you have, the more debt you accumulate, and the harder it is to improve your score. If your score is too low to qualify for any credit card, let alone one with a high-interest rate, then it can feel like a Catch-22. But there are some options available that can help you and these are offered to borrowers with low credit and no credit.

Secured Credit Cards

If you’re being refused for unsecured credit cards, you can apply for a secured one. A secured credit card works in much the same way, only it’s “secured” against a cash balance and is available from numerous offline and online lenders.

You place several hundred dollars on the card and then use it just like you would a normal credit card, only instead of spending credit that you’ll have to clear in a month’s time, you’re spending the money you’ve already deposited. Your money becomes your collateral, which eliminates the lender’s risk and makes you a viable customer even if your credit score is terrible.

It may seem like a pointless endeavor, but a secured credit card can help you to build your credit score and is one of the few options available to consumers with little or no credit. It also provides you with a safe, secure, and convenient payment method, one that can be used online and offline. What’s more, if you stick with the same provider for several months, they may upgrade you to an unsecured credit card.

Buy Now, Pay Later

Services like Klarna and Affirm have changed the retail landscape in the last few years and have helped online retailers to boost their sales significantly. But they’ve also caused many problems for inexperienced consumers and left countless young people in debt.

These services work on a “buy now, pay later” system. You can buy the products that you want right now, and you don’t have to worry about paying for them until a few weeks have passed. However, if you miss those payments, your credit report will suffer and these seemingly straightforward installment loans become just as complicated and damaging as credit card debt and overdue student loans.

They are freely available and not secured against anything, but you need to be very careful when using them. In most cases, you’re better off using your credit card to complete that purchase.

Lending Circles

A lending circle is basically a community of lenders that exchanges money to help members when they need it the most. The simplest way of understanding a lending circle is to imagine that you have ten friends and every month you all agree to give one friend $50. During the first month, Friend 1 gets $450 from the others and can use this to do with as they please—making renovations, throwing a party, paying bills. In the second month, Friend 2 gets the $450 and the cycle continues, with the friends taking turns to become both the lender and the borrower.

Everyone gets their turn, everyone pays the same, and everyone can benefit from spending a small, fixed sum of money every month and getting a large sum once or twice a year.

Online lending circles are a little more complicated and beneficial, however, as their main goal is to help members improve their credit scores. There are costs involved with these online services, but when you consider the benefits they can bring, those costs are usually worth it.