- Know the difference between Unsecured and Secured debts.
- Revolving debts have different repayment methods than installment loans.
- Know the credit impact and repayment challenges of each debt type.
Learn About the Types of Debt and Differences Between Unsecured Debt and Secured Debt
There are a variety of types of debt. There are good debts and bad debts. It is important to understand debt and use borrowing strategically, so that you do not end up with a debt problem. If you have a debt problem, it is imperative that you take charge of the situation and solve your debt concerns the best way possible. This article discusses the two general types of debt to help you become an informed and educated borrower.
Types of Debt
There are two primary categories of debt: Secured Debt and Unsecured Debt. These then break-down in multiple sub-categories, including revolving, installment, and mortgage. In credit reporting, mortgage debt has the highest weighting on your credit score, then installment loans, and then revolving loans.
Secured debt describes a debt that is secured by an asset that acts as collateral. With a secured debt, your lender has a security interest in the asset that you use as collateral. In business terms, this means an "asset-based-loan" and for consumers this typically means a home loan mortgage, an auto loan, a boat loan or any other type of loan secured by something. A good thing about secured loans is that they are less risky for the lender. They typically come with a lower interest rate, since the lender's risk-based pricing allows this to be a cheaper source of financing. An additional benefit of one specific secured debt, a mortgage loan, is that the interest is tax deductible which makes the effective interest rate even lower.
The concern with secured debts is that if you default, the consequences are severe, including repossession or foreclosure on the asset. Unlike credit cards, medical bills, or other unsecured debts, if you default on a mortgage you will face foreclosure. If you default on a car loan or an other asset based loan, you may face repossession.
Unsecured debt describes a debt where you have an agreement to repay your lender, however, no asset is used as collateral to secure the loan. The most frequently used unsecured debt is credit card debt. Most credit card debt is a type of revolving debt, where your balance can go up or down and your main obligation is to repay the minimum monthly payment. Credit card debt can carry high interest rates, with national averages approaching 15% APR.
Student loans and some other forms of personal loans are also unsecured, however are known as installment loans. This means that the loan is repaid in straight-line periodic installments that do not vary and typically you cannot add to the balance, unlike credit card revolving debt. Medical bills also usually fall into this bucket.
A payday loan is an unsecured loan with extremely large interest rates. Payday loans require repayment immediately after the borrower receives his next paycheck. Loan amounts are usually small; they are based on the size of the borrower's paycheck. Because of the high interest and heavy penalties, once a borrower falls behind on a payday loan, it is difficult to catch up. This is a product that should be avoided, if at all possible.
Typically unsecured debts have the highest interest rates. Defaulting on an unsecured debt leads to penalties, fees, and potentially to collection efforts. The main problem with unsecured debt is the high cost, as it usually is riskier for the lender. The benefits are that it is easier to qualify for, is frequently convenient, and, in the event of default, there is no asset is at risk.