As the lending institutions are coming up with different types of loans, it is always better for the prospective buyers to generate some awareness about the basic debt types, and their financial as well as legal implications.
Secured Debt: A secured debt is secured with a collateral. To be more precise, the borrower pledges certain assets as collateral, for obtaining the loan. This collateral can be acquired by the lender, in case of default made by the borrower, in loan payments. One of the common example for secured debt is mortgage loans. Even car loans can be categorized as secured debts. In case of purchase of real property with mortgage loan, the property is pledged as a collateral. If the borrower fails to make mortgage payments, the lender may resort to short sale or foreclosure, so as to realize the debt amount. The same applies to car loans, wherein the vehicle is used is as the collateral.
Unsecured Debt: In case of an unsecured debt, there is no such collateral, that can be used by the lender, if the borrower defaults in debt repayment. The lender is not entitled to seize any property of the borrower, so as to realize the debt, in case of default. However, the lender may obtain a legal judgment against the borrower, as a recourse to collect the debt amount. Credit card debts and personal loans are classic examples of unsecured debt.
Difference Between Secured and Unsecured Debt
Lender’s Risk: The basic difference between a secured and an unsecured debt is with regard to the collateral. So the lender is more secured in case of a secured debt, and the risk associated with lending is very low. In case of an unsecured debt, there is no guarantee for debt repayment, and so these loans are associated with a high level of risk on the part of the lender.
Interest Rate: The percentage of risk is reflected in the interest rates too. As secured debts are associated with low risk levels, the interest rates are found to be lower, whereas it is much higher in case of unsecured debts.
Monthly Installment: Most of the secured debts are installment debts, wherein the borrower is required to pay a predetermined monthly installment for a set period, within which the debt has to be repaid. But unsecured debts are mostly revolving debts, in which the interest rates and monthly installments may vary.
Borrower’s Risk: In case of default in repayments of secured loans, the pledged assets are at risk, and can be acquired by the lender. In case of unsecured loans, defaults can affect the credit history of the borrower, who may find it difficult to fetch loans in future.
Even though secured debt consolidation is mostly favored, it also runs a risk of losing pledged assets. Unsecured loan consolidation will require you to pay very high premiums. In short, a basic idea about the difference between different types of debts may prove useful in understanding their financial and legal implications. However, make sure to consult a financial adviser, for effective debt management.