As you begin your own personal adventures in credit and debt land, you’ll notice an interesting phenomenon: borrowing rates vary quite dramatically from one type of loan to another.
Credit cards, for example, can have interest rates north of 20%, while mortgages are currently hovering at historic lows of around 3-4%. Student loan rates, meanwhile, are at 5% and above if unsubsidized by the government. So much for getting a “noble cause” good debt discount, eh?
So what’s behind this rate variance phenomenon?
At its root, the rates are fundamentally connected to their nature of being tied to secured loan or unsecured loan.
Lets review what each is and then get in to what types of credit fall in to each category.
Secured Debt
Secured debt, is a loan that is backed up by collateral (a physical asset that the lender places a lien on and can be taken from you).
The collateral is security for the bank in the event that you default (don’t pay back what you owe). In other words, if you do not make your payments, you may lose the possessions that you purchased via the credit given to you.
Nobody wants to get their stuff taken away from them by force of the bank, so secured loans are much more likely to be paid back in full by the debtor (you). And there is physical property to cover any potential monetary losses by the lender.
As a result, secured loans are less risky to the lender. And this is why secured debt often comes with lower effective APY (interest rates) than unsecured debt.
Types of secured debt include:
- mortgages
- home equity loans and HELOC’s
- auto loans
- retail financed purchases with a security agreement (if you don’t pay you have to give back)
- secured personal loans
Unsecured Debt
Unsecured debt, on the other hand, is a loan that has zero collateral behind it. This makes it riskier to the lender because in the event of default, nothing can be physically taken away from the borrower to cover the lender’s losses. Unsecured debt is riskier because default is more likely, as there is no threat of losing possessions. And because of it, they typically carry higher effective APY’s. Often times, the interest rate is variable and is tied to the prime rate.
Does this mean that you should not worry about defaulting on unsecured debt? No!
For starters, to do so would destroy your credit, as the lender would report the delinquency to the credit bureaus. This would prevent you from being able to secure debt at good rates (sometimes any rate) in the future. It could also lead to incessant hounding from collection agencies and creditors until you pay them off, and the harassment and stress that comes with that.
In extreme cases, it could lead to the lender pursuing legal action against you, and if they win, they may be able to garnish future wages to pay off your debts or put liens against your property. This is rare, but it does happen.
Types of unsecured debt include:
- credit cards
- student loans
- medical bills
- utility & telecom bills
- financed retail purchases without a security agreement
- payday loans
Secured Debt vs. Unsecured Debt: which Should you Prioritize?
There’s no such thing as “good debt”, as some like to say – some is just less crappier than others.
If you have to take on debts, always pay off each religiously, every month, in full.
If you lose your job or otherwise find yourself in a situation where you can’t do this, you have some tough decisions to make.
Start by selling off assets you don’t need to pay the bills and taking on any additional work you can find to boost your income and ability to pay off your debts. After that, you’ll have to make a choice on which loans to prioritize.
Despite unsecured loans having higher interest rates that could quickly add up in the event you don’t pay, you typically want to focus on paying off your secured loans first.
There’s two reasons for this:
- Essential Assets: you don’t want to lose an essential asset like a roof over your head or transportation to get you to/from a job.
- Leverage: no lender wants to have to pay legal fees to take you to court for an unsecured loan. You can often work out deals with the lenders, if necessary, which may include them forgiving some of your debts (make sure you get everything in writing).
If we’re talking about on-essential assets that are secured (a TV, for example), then this could be an exception to this rule.
If you are making your payments in full every month and have additional cash to apply towards your debt to pay it down? Forget everything I just said. In my opinion, you should put everything towards the highest interest debt until it’s paid off in full, then move on to the next highest interest debt, and work your way down the line. I’ve discuss debt payoff strategy before and I’m not a fan of the Dave Ramsey debt snowball strategy. Money is money – save as much as you can!
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I think I have to disagree with you on this one, I personally view unsecured debt as being the most evil of all debts. They do nothing but reduce your overall net worth. At least with secured debt there is a hard asset behind it and at the worse, it breaks even when taking you net worth into account. You may be wondering why I focus so much on my net worth. Simply put, if everything in my life were to financially fall apart, that’s the number that I would have to start over if I were to liquidate everything and pay off all my debt. I do agree that as far as prioritizing debt the focus should be on the high interest debt.
I think unsecured debt is the worst simply because if something tragic happens I cant file bankruptcy and lose my student loan debt, the “knowledge” is not able to revert back to the lender. My goal is to pay down my mortgage as much as possible since that has the lowest interest and use equity to pay off student loan debt (since I have over $100k).
I also think you need to consider cash flow when figuring out which debt to pay down first. My car loan is 5% and my student loan is 6.8%, but because of their different timelines, they have different impacts on my cash flow. Paying off my car loan first gives me more cash each month than paying off the student loan. I know it will mean paying more in the long run for the one with the higher rate, but I need more cash now each month. And that’s where I get stumped.
I would also have to disagree. If your cash flow is not sufficient to cover your debt payments then you need to make some serious adjustments to get your cash flow back in place so you can make payments (sell stuff, reduce life style, etc. . ). Then the most “efficient” way is to pay on the highest rate loan first then roll those amounts onto other debt after it is paid off. A lot of people advocate paying the smallest first (and i can see their point about this working best given most people natural ways). However I don’t think secured vs unsecured really needs to enter into the picture (becuase you have already adjusted so you can cover all your debt payments right????). One final though would be to leave any debt on assets that are appreciating to the last (think house) as it is the least bad of the debts (although still bad).
Very good information. Even though it may not matter to the borrower, it’s nice to know the difference between debts. By the way, I completely agree with you about paying off the highest interest rate loans first, no matter the amount. I think Dave Ramsey’s debt snowball method is for the people who don’t completely understand interest rates and just need to get some momentum going on paying off their debt. This may work for those people, but the smartest way is to do it the way you suggested.
Studies have shown that for debt elimination the dave ramsey snowball method is actually one of the best predictors of paying off your debt and staying out of debt. Paying off highest interest rate debt first is preferred (which is typically consumer debt and unsecured), it takes discipline that many have to work to cultivate. Great method for those just starting out.
I don’t think paying off secured debt should be the primary objective. I believe staying current of these loans is most important.
Most of these contracts are installment payments. If you make your installments on time, you keep the car, house, etc. There is no credit scoring bonus for paying off an installment contract early.
After staying current on secured loans first, paying off the revolving unsecured lines provides the greatest savings, and boost to your credit score.
In my opinion secured debt is best avoided at all costs, although some forms such as a mortgage are almost impossible to steer clear of completely. You offer some really clear observations and i agree that highest interest debt should be tackled first to avoid the dreaded compound interest taking took much of a grip
Agree. Pretty much all debt besides a morgage (and maybe some small student loans) is easily avoidable. The question though is if you have the debt which should you pay off first. Probably the wrong question to even ask. Better question would be how can I pay off all of my debt the fastest!
Overall good points! While I agree that paying off high-interest unsecured debt should be an absolute priority, let’s not forget about the tax benefits a mortgage and a student loan provide.
Absolutely, Tim. The tax benefits of a mortgage and student loans really remove the incentive to pay them off early.
Does the TAX benefits really outweigh the monthly payment? my month payment is 1800$.
I personally would pay off any adjustable rate debts first, prior to move to fixed rates. The Federal Reserve can’t keep rates low forever, and once the bond bubble bursts it’s going to be hard times for everyone with adjustable rate debt.
Snowball vs Avalanche seems to be an eternal argument on PF sites. In my mind there is no ONE SINGLE right answer for an individual. IT’s up to them to use whatever method works best for them. Myself, I have a preference for the Avalanche method. But i’ll make exceptions to that, if I have a debt with a few hundred dollars left on it i’ll divert some of the “avalanche” money to it and get it out of the way then use the freed up payment to apply towards the “Avalanche” debt I’m working on. Does it make mathematical sense? Nope, but it makes me feel a heck of a lot better about my debt picture.
Right. The quesiton should be how can “I” pay off all of my debt the fastest! If the snowball works for you, go for it. There isn’t a wrong answer for saving money on interest by paying off debt.
Hello,
I was trying to locate your contact form but no luck,
I can’t find it. Can you please email me the link to it?
Thanks much!
Cris
I don’t think it matters, only if one has a secure job and income. If those factors apply, utilizing the debt snowball would be a great method of paying down the debt.
However, if one were to have a shaky financial picture, paying down secure debt would be a good idea.