One of the most important distinctions to understand in personal finances is the difference between secured debt and unsecured debt. Whether or not your debt is secured can make a big difference in how you proceed in a number of different financial situations.
Secured debt is debt that uses some asset as security. You pledge an asset in return for getting the loan. If you default on the loan, the lender has the option of repossessing the asset in order to help recoup the money lent to you. A mortgage is a good example of secured debt. If you don’t make your monthly payment, then your home could be foreclosed on. A car loan is another example, since the lender can repossess your car if you stop making payments. Sometimes, you may have to offer collateral — such as a valuable piece of jewelry — to get certain loans.
With secured debt, you can often get better interest rates, and the ability to borrow more money. This is because the lender has some assurance of limiting losses since there is an asset available to seize if things go wrong on your end.
On the other hand, unsecured debt is credit that does not require collateral. Credit cards are excellent examples of unsecured debt. Lenders can sue you for the money that you owe, and try to force some sort of repayment through legal means, but creditors cannot seize your home in order to help limit losses due to your default. Lenders that allow unsecured loans are taking a bigger risk of loss, and so may charge higher interest rates, or limit the amount that you can borrow.
Which to Pay First?
When it comes to making a decision about which bills to pay first, it is often a wise idea to pay your secured debt first. This is because some asset of yours may be at risk. If you are interested in keeping your home, you should make sure that your mortgage is paid before you worry about making credit card payments. If you don’t want to lose your car, you need to make efforts to make auto loan payments. Secured debt can mean the loss of an important asset if you don’t pay.
Securing Unsecured Debt
Another thing to be wary of is securing unsecured debt. This is when you take unsecured debt and the secure it with something. One of the most common ways people do this is to take their credit card debt and consolidate it with a home equity loan. It is true that you can get a better interest rate (that may even be tax deductible) when you do this, but you are also taking a big risk.
What happens if you can no longer afford the home equity loan? You have taken your credit card debt, which couldn’t threaten your home before, and made it much more threatening. Before you secure your unsecured debt, it is important to carefully consider your options, and make a decision about what might be best in your situation. In some cases, it might be better to keep your unsecured debt unsecured.