Secured Debt: What It Is And How To Pay It Off
PUBLISHED: Mar 29, 2023
When you finance a car, borrow a mortgage loan or make a purchase with a credit card, you’re taking on a form of debt. This debt is classified as either secured or unsecured, and debt that’s backed or “secured” by collateral – like a new car or house – is known as secured debt.
Understanding examples of secured debt, as well as the differences between secured and unsecured debt, can help borrowers better prepare to pay back the money they owe. Let’s take a look at what secured debt is and how it works for borrowers and lenders.
What Is Secured Debt?
Secured debt is a type of debt that’s backed by a form of collateral – like a vehicle, property or other asset – that serves as a physical security for the creditor or lender in the event the borrower defaults on the loan.
When you take out a mortgage or a car loan, you agree to make payments on the loan until it’s paid off. If you stop making payments on the loan for any reason, the lender can repossess the asset and resell it to cover the money you still owe on the loan.
Secured debts are less of a risk to lenders than unsecured debts because lenders are guaranteed they’ll recoup their losses even if the borrower defaults.
On a more positive note for borrowers, secured debts typically have better interest rates and lower credit score requirements than unsecured debts. If you experience financial hardship, however, you may risk falling behind on your loan payments and losing the asset you put up as collateral.
Secured Debt Examples
Secured debts come in many forms. We’ve listed some of the most common ones below.
- Mortgages: Any type of home loan is considered a secured debt because the house serves as collateral.
- Auto loans: Your vehicle is used as collateral when you take out a car loan.
- Home equity lines of credit (HELOCs): Like with a mortgage, your house is used as collateral when you take on a HELOC. If you stop making payments, the lender could foreclose on the property.
- Land loans: The land you purchase with a land loan is used as collateral if you default on the loan.
- Home equity loans: When you take out a home equity loan, your house is used as collateral.
- Secured credit cards: Getting a secured credit card requires an upfront cash deposit that functions as collateral for the bank in the event you miss your credit card payments.
What Is Unsecured Debt?
Unsecured debt isn’t backed by collateral. This means you aren’t required to use an asset, like your house, as a security in case you default on the loan or stop making your monthly payments. Examples of unsecured debt include regular credit cards, student loans, medical bills and most personal loans.
So, what happens when a borrower defaults on or stops paying an unsecured debt? It really all depends on the type of unsecured debt. Missing one or more credit card payments, for instance, can result in late fees and interest charges. It can also directly lower your credit score.
If a borrower defaults on an unsecured loan, like a personal loan, the lender can seek legal action against the borrower in order to receive the money that’s owed.
Because unsecured debts are riskier for creditors and lenders than secured debts, you’ll have to meet stricter requirements to qualify. This typically means having a higher credit score and lower debt-to-income ratio (DTI), though requirements can vary by lender or creditor.
What’s The Difference Between Secured Vs. Unsecured Debt?
Let’s take a look at some of the most prominent differences in secured versus unsecured debt.
Presence Of Collateral
Secured debts like mortgages and auto loans use collateral to protect the lender in case a borrower defaults on the loan. Unsecured debts aren’t backed by collateral. However, borrowers with unsecured debt will still have to face the consequences if they default on their loan or stop making their debt payments. These borrowers could incur late fees, or their credit score could plunge.
Credit Score Requirements
Secured debts tend to have a lower credit score requirement than unsecured debts. Because unsecured debts pose a greater risk to lenders, lenders want the reassurance that borrowers will pay back the money they owe. So, the credit score requirement for an FHA loan might be lower than the credit score needed to apply for a credit card.
Terms And Conditions
Interest rates are typically higher on unsecured debts than secured debts. For example, interest rates on credit cards can average between 20% and 24%, while the interest rate on a 30-year fixed-rate mortgage with Rocket Mortgage® is around 7%. Borrowers can also often get a longer loan term or higher credit limit on a secured debt than an unsecured debt.
How To Pay Off Secured And Unsecured Debts
One of the similarities between secured and unsecured debts pertains to repayment. Whether you have a credit card or car loan payment, the goal is to ensure the payment is made on time and that the debt is eventually paid off in full.
Because borrowers may not owe just one type of debt, it’s important to consider the best ways to make timely payments and pay down various debt areas. Let’s explore some strategies for paying off both secured and unsecured debts.
Snowball Method
If you’re actively looking to pay down debt, one of the best places to start can be with the smallest debt you owe. With the snowball method, you work to pay off the smallest debt in its entirety. Then, like a snowball rolling down a hill, you gain momentum to pay off the second smallest form of debt, and so on, until you’re debt-free.
This doesn’t mean entirely avoiding other areas of debt in your life, though. While you work to pay off the smallest amount of debt (let’s say, a credit card with a $1,500 balance), you would also make minimum payments on your student loan, auto loan and other debts.
A downside of using the snowball method is that it can take longer to pay off all of your debts compared to the avalanche method. Because you’re tackling your debts from smallest to largest, the snowball method might also cost you more in interest payments in the long run.
However, the point of this method isn’t to save time or money on interest payments, but it’s to show that you can do it and give you the motivation to continue paying off all of your debts completely.
Avalanche Method
The avalanche method is a bit more of an aggressive approach to paying down debt. Here, you start with the debt carrying the highest interest rate. This might mean targeting a high-interest credit card or student loan before other debt payments. Like the snowball method, though, you’ll still want to make minimum payments on your other debts while you tackle the high-interest debt.
The goal of the avalanche method is saving money on interest payments, even though paying off a single debt can take more time than with the snowball method. But once you’ve completely paid off one area of debt, you’ll have the confidence to work on other debts in your life.
Keep in mind that the snowball and avalanche methods may not work for a debt like a mortgage loan. That’s because some lenders charge a penalty for paying off your mortgage early. If this is the case, continue making your scheduled monthly mortgage payments while you work on paying off other areas of debt.
The Bottom Line
Secured debt is a form of debt that’s backed by an asset, like a house, that a creditor or lender can seize if a borrower defaults on the loan or stops making their monthly payments. To avoid the consequences of not paying off your debts, it’s important to keep all of your monthly bills and debt payments organized so you don’t miss a beat.
The Rocket Money℠ app is a great place to start with organizing your finances. It connects all of your accounts and keeps your bills in one place so you know exactly how much you owe – like for an auto loan payment – and when you have to pay it.
Take debt management to the next level and download the Rocket Money app today.
Victoria Araj
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