Debts fall under two broad categories: secured and unsecured.
The difference between the two lies in whether the borrower puts up collateral for the loan. Although the difference is a simple one, it has profound implications for the loan’s pricing and the consequences of defaulting.
As you explore financing options, keep the following differences in mind, particularly as you prioritize which loans to pay off first.
Secured Debt
Lenders sometimes require collateral when you borrow money. When they do, they “secure” the debt with that collateral, so that if you default they repossess the collateral to sell and recover some or all of their loaned money.
In most cases, lenders don’t physically take possession of your collateral when they issue the loan. Instead, they secure it with a lien: a legal right to take possession of your collateral only in the event that you default. Liens are recorded on public record through documents such as signed “deed of trust” or “mortgage” declarations.
Note that multiple liens can exist on the same collateral. For example, homeowners can have two mortgages. These liens get recorded in a specific order, with the first lien position taking first priority. In the event of a default, the first lienholder gets paid first, and the second only sees repayment from funds leftover after the first lienholder has been repaid in full.
Beyond using the collateral to sell and recover loaned money, lenders also take collateral to create a greater incentive for the borrower to repay their loan as agreed. There’s a reason why personal loans have far higher default rates than mortgage loans.
By securing collateral, lenders reduce the risk of default, which allows them to charge less for secured loans. Remember that the business model of lending money revolves around risk: the greater the risk, the more the lender has to charge to justify risking their money. Loans are investments for the lender, and investors require higher returns if they are to take on higher risk.
Common Types of Secured Debt
Although any loan secured with collateral qualifies as a secured debt — such as demanding your friend’s watch before lending him $200 — there are a few common secured debts that everyone should recognize.
Mortgage Loans
The classic example of secured debt, a mortgage lets you move in and take possession of a home without having to pay for it in full out of your own pocket.
Upon buying with a mortgage, you sign a deed of trust or mortgage document that secures a lien against the property for the lender. If you default, the lender can file to foreclose: to take possession of the property to sell it and recover their loaned funds, plus late fees, legal fees, advertising fees, and so forth.
But the collateral alone doesn’t determine the loan’s pricing. Lenders also look at the borrower’s credit history, the stability of their income, their cash reserves, and their emergency fund. Keep in mind that a collateral’s incentive plays a role in mortgage pricing too, not just the value of the collateral itself. Lenders charge far more for mortgages against investment properties, for example, than against primary residences. Why? Because they know that borrowers will default on an investment property loan first, rather than risk losing their primary residence by defaulting on their home mortgage.
HELOCs
A home equity line of credit (HELOC) is a rotating line of credit, similar to a credit card, but secured against real estate. You can pull money from it, then pay it back on your own schedule — at least until the draw phase ends and the repayment phase begins, at which point it must be repaid with regular payments like a mortgage.
Homeowners can use home equity loans and HELOCs through companies like Figure.com to access equity in their home. Short of selling the property, secured debt is the only way homeowners can pull equity from their home to put to use elsewhere.
Auto Loans
When you approach a bank to negotiate a car loan, there’s one point that’s not negotiable: the loan must be secured against the car. Should you default, the lender can repossess your car and auction it off to recover their money.
Again, that collateral reduces risk for the lender, which in turn lowers the cost for you to borrow. Compare auto loan interest rates to, say, unsecured personal loan rates, and you’ll see a sharp contrast in pricing. Auto loan rates are much lower because the lenders know they have collateral to secure their investments.
Equipment & Other Secured Business Loans
Businesses can borrow more money at lower interest rates when they can put up collateral.
For example, businesses that need expensive equipment can often put that equipment up as collateral in order to qualify for better loans. It’s why, when you first apply for a small-business loan, the loan officer first asks a series of questions about the business’s assets. They want to get a sense for your collateral, which largely determines your eligibility and the terms of your loan.
Secured Credit Cards
People with bad or no credit history tend to have trouble opening high-reward credit cards. In order to establish and improve their credit, they have to start by offering the card company some kind of collateral.
Enter: secured credit cards. You deposit a certain amount of cash with the credit card company as collateral, and they issue you a credit card. But it’s a true credit card, not a debit card — charges on the card don’t come out of your cash balance. You accrue a credit card balance, you (hopefully) pay it in full each month, and the card company reports your balance and payment activity to the credit bureaus. That helps you build good credit, assuming you pay your bill on time and ideally pay the balance off each month.
If you stop paying your secured credit card bill, the card company can tap into your cash balance to recover their money.
Unsecured Debt
In contrast, unsecured debts have no collateral to protect the lender if you default. These types of credit are based solely on the creditworthiness of the borrower.
That means lenders typically charge much more for them. Remember, lenders price loans based on their risk.
If you default on an unsecured debt, the lender can’t simply repossess a piece of collateral to sell and recoup their losses. They have exactly one option: filing for a legal judgment, and then trying to collect it.
Yes, judgments hurt your credit. And yes, creditors can jump through some legal hoops to forcibly collect judgments, such as garnishing your wages. But the overwhelming majority of judgments are never collected because they’re often more trouble for creditors to collect than they’re worth.
Common Types of Unsecured Debts
Although not all unsecured debts start as loans, many do. As you look for the most cost-effective ways to borrow money, keep in mind that unsecured loans tend to cost more in interest, although they sometimes make up for it in lower initial borrowing costs. It costs a lot of money to run a title search and record a lien against a home.
Credit Cards
Although secured credit cards do require collateral, as outlined above, they certainly aren’t the norm. Most credit cards are unsecured and charge high interest rates often exceeding 20%.
Card companies typically determine your credit limit based on two risk factors: your credit history and your income. People with better credit and higher incomes can qualify for cards with more cash-back rewards, travel rewards, and other perks, and for lower-APR credit cards.
Consider it one more reason to improve your credit.
Personal Loans
Being unsecured, personal loans cost far more than auto loans or mortgage loans.
At the time of this writing, Bankrate reports the average personal loan interest rate as 11.91%. Meanwhile, the average new car loan interest rate was less than half that for borrowers with good credit, at 5.01%.
Personally, I’ve always preferred keeping unused, high-reward credit cards in reserve as a hedge against unforeseen expenses instead. They’re infinitely more flexible than personal loans, and don’t necessarily charge much more interest. Just don’t let these debts accrue — pay them off so you don’t get so swamped you start considering a debt consolidation loan.
If you want to build wealth and avoid pointless debt, steer clear of personal loans and instead pay for your expenses with savings or, in a pinch, a reward-bearing credit card you pay off as quickly as possible.
Student Loans
Unlike personal loans, student loans serve a clear purpose: investing in your education.
Student loans come in many stripes; subsidized and unsubsidized, direct and indirect, federal and state, or private student loans. In most cases, the lender takes no collateral. But because these loans are often subsidized by the federal government, the interest rates remain artificially low. At the time of this writing, the average interest rate for undergraduate student loans is only 2.75%, according to StudentAid.org.
Pro tip: If your student loans have an interest rate above the national average, you should consider refinancing. This will reduce your interest rate and decrease the amount you’ll pay over the life of your loan. Check out our list of the best student loan refinance companies.
Unsecured Business Loans
Not all business loans are secured by the business’s assets. Many business loans remain unsecured, based largely on the personal credit of the owners and the business’s credit history.
As such, these loans sometimes come with high interest rates. But as with every other type of loan, the stronger your credit, the less you can expect to pay in interest and fees.
Medical & Other Bill Default Debts
Although not loans, you still incur a debt when you don’t pay your bills.
This goes for everything from your utility bills to your cellphone bill to medical bills. Fail to pay, and the service provider seeks a judgment.
In the case of medical bills, you can avoid sticker shock by maintaining adequate health insurance. And depending on the bill, you may also qualify for emergency financial assistance.
In What Order Should I Pay Off Debts?
Yes, there is a specific order in which you should pay off your debts. Sort of.
The two predominant strategies for paying off debts — the debt snowball and debt avalanche methods — both work great. In the debt snowball method, you pump all your spare money each month into your smallest debt first, paying only the minimum payment on all other debts. Once you pay off the smallest debt, you move on to the next smallest. Then the next, and with each debt you pay off, you can funnel more money into each successive debt each month.
The debt avalanche method works nearly identically, with one twist: instead of ordering your debts by size, you order them by interest rate, focusing on your highest interest debt first. Mathematically, it can save you a little money on interest. But for many, the psychological boost and sense of achievement you get when you pay off those early, small debts helps reinforce the behavior and keep you motivated to pay off your debts quickly.
Regardless of which strategy you use, I recommend starting with your unsecured debts first.
As outlined above, unsecured debts tend to come with higher interest rates. Focus on your credit card debts first and foremost to avoid paying 15% to 25% interest on consumer debt. All the while, avoid racking up any fresh consumer debt, so you don’t end up running on a financial treadmill for the rest of your life.
Leave secured debts for later. In most cases, for example, you should pay off your student loans long before paying off your mortgage early.
Because you can borrow secured debts like mortgages and auto loans pretty inexpensively. If you can borrow a mortgage at 3.5% and a car loan at 5%, and you can earn a 10% average return on stocks, then it typically makes more sense to invest rather than pay down those cheap secured debts.
Even the notoriously debt-averse personal finance guru Dave Ramsey urges you to invest for retirement long before fully paying off your mortgage in his famous Baby Steps.
But make paying off your unsecured debts a priority, because it’s hard to build wealth while paying exorbitant interest on old debts.
Final Word
As a general rule, look to avoid debts. But keep in mind that not all debts are created equal.
Some debts serve a clear and productive purpose; buying a home with a mortgage can actually save you money compared to renting a similar property in your market. Then again, there are the credit card debts you racked up on your last shopping spree.
Use the debt snowball or debt avalanche method to pay off your unsecured debts starting today. Your mortgage and auto loan, in contrast, can wait a bit lower down your priority list.
What are you doing to tackle your debts? Which ones are you trying to knock out first?
