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, 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:
- 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, 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!