There are only two main types of debt: secured and unsecured. That means all the debt you acquire such as your car loans, student loans, and credit card bills belong to one of these two categories.
You should know the difference between the two as it will let you know which debts to prioritize during payoff or in times of financial crisis. If you know which bills to prioritize, you can avoid losing assets tied to your debt.
Secured Debt
This type of debt requires some form of collateral. It needs a valuable asset that can surely be ceased and liquidated when you fail to keep your end of the bargain. It will then be used to cover your remaining debt; hence the name – secured debt.
Think about your mortgage. Your lender considers your home as collateral. If you fail to pay your dues, your lender can initiate foreclosure proceedings and assume possession of your house. The same principle applies to car loans. But in this case, your car will serve as collateral, not your home.
Lenders require collateral as a security measure. They do it to protect themselves when they’re handing out large loans. Knowing what’s at stake, borrowers are more likely to pay their bills on time. But when they do stop making their payments, lenders can make up for their losses by ceasing the collateral and selling it.
What Assets can be Used as Security?
Different types of assets can be used as collateral. Below you will find a list of items that you can use as security for a loan.
- Property. If you own a house or hold equity in a mortgaged property, you can use that as collateral.
- Vehicles. Lenders typically accept brand new as well as old cars for collateral. You can even use motorcycles, boats, and jet skis.
- Term deposits. Lenders are often willing to accept the amount in your term deposit as security for a loan.
- High-value assets. Depending on the lender, you might be able to use expensive jewelry, art pieces, and more as collateral.
Unsecured Debt
When it comes to unsecured debt, lenders have no right to take possession of a collateral. Even if you fall behind on your payments, they can’t seize any of your assets. Credit card bills, student loans, and medical bills are a few examples of unsecured debt.
Since lenders have no collateral to take over, they would usually use other means to get you to pay your bills. They could, for instance, utilize the services of a debt collector. They might also take legal action. Lenders may also report your delinquent payments to credit bureaus, and it will reflect on your credit report.
To note, lenders of secured debts may take similar actions before proceeding to seize your collateral.
Knowing Your Priorities
When you’re in a pinch and do not have enough money to pay all your dues on time, experts from overdraft apps say it’s always best to prioritize your secured debts. You must pay them first as they are frequently harder to catch up on because they tend to cost more compared to unsecured debts.
Though failing to pay unsecured debts will affect your credit score, at least you can enjoy the pleasures of your home and your car.
On the other hand, if you’re trying to make extra payments to clear off some debt, you can prioritize unsecured debts. They tend to have higher interest rates, which means they will get more expensive the more you hold off on paying them.
What Type of Loan is Best for You?
You need to look into several factors when you’re choosing between a secured and unsecured loan. Though both options will provide a way to finance a purchase, you should still go with what’s best for your needs. Compare the opportunities that both sides present, and choose the option that can deliver what you need.
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- Maximum loan amounts. Secured personal loans come with higher loan amounts due to the fact that they involve less risk compared to unsecured debt.
- Interest rates. Again, secured personal loans come with fewer risks for lenders, and for that reason, they tend to have lower interest rates than unsecured loans.
- Fees. There isn’t much of a difference between the two types. It ultimately depends on the lender. Some charge fees to establish the loan, others won’t.
- Credit requirements. Lenders of secured loans can repossess assets and sell them to recover from losses. That’s why they are more lenient about credit requirements.
- Loan terms. If you’re applying for a fixed-rate loan, both secured and unsecured loans will land you a term ranging from one to five years. You may have a one to seven-year loan term if you take variable-rate loans.
- How you can use the funds. Lenders of secured loans often limit the ways you can spend the funds. Let’s say you took out a car loan. The lender may require you to use the money solely for paying your vehicle. For unsecured loans, lenders tend to be less strict about this, and you would most likely be able to use the money for whatever purpose.
Before you decide, review your credit report and scores. It should lead you to make an informed borrowing decision.
Practice Responsible Borrowing
Most financial experts would tell you to follow the 28/36 rule. This rule suggests that a household should spend no more than 28% of its gross monthly income on total expenses, including rent and mortgage bills. Total debt payments should also not exceed 36% of the monthly income. This rule indicates that debt loads that go over the 28/36 rule would be difficult for an individual or an entire household to service, which may only result to default.
You can use this rule of thumb when you’re planning your monthly budget. You should also use it when you’re applying for any type of credit as it’s the standard that most lenders follow when they’re assessing borrowing capacity.
