Debt comes in two varieties: secured and unsecured. In most cases, you don't get a choice between the two: The type of debt is determined by the type of loan you're applying for.
Still, it pays to understand the differences between secured and unsecured debt, especially if you have multiple loans that you're trying to pay off at once. Here's a quick overview of what you need to know.
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Secured debts are linked to an asset, like a home or a car. When you apply for a secured loan, you're not just making a commitment to pay back what you owe -- you're also giving the lender permission to seize the asset in question if you can't make your payments.
For example, if you take out a car loan, and then, for some reason, you're unable to pay back the money you borrowed, then the lender is within its rights to seize the car and sell it in order to get back the funds it lent to you. If the asset is valuable enough to cover the debt, you're off the hook. But if not, the lender still can come after you for the remaining balance.
Secured loans pose less risk to lenders because they give lenders a means of recouping their money if you fail to pay. In exchange for securing the debt with your property, you'll generally get a relatively low interest rate -- but there are strings attached. Lenders require you to insure the asset tied to the loan -- the home or car, for example -- as a condition of the loan agreement. This is another means of protecting their investment; if the asset is destroyed in an accident and you stop paying your bills, then the lender can still recoup at least some of its money.
Unsecured debt, such as a personal or student loan, doesn't have an asset attached to it. Lenders are essentially trusting your word (and your credit history) when you promise to pay back what you borrow.
If you default on the loan, the lender can still come after you for the money by suing you and tarnishing your credit report, but it typically can't seize any of your personal property as a means to recoup its losses. And if you choose to declare bankruptcy, the creditor may never get its money back at all.
This makes unsecured loans a risky proposition for lenders, and lenders often charge higher interest rates to compensate for that risk. It's not uncommon for personal loan interest rates, for example, to exceed 10%, even for borrowers with excellent credit. Meanwhile, the average mortgage interest rate today is under 5% because the house serves as collateral.
Which type of debt should I pay off first?
Ideally, you'll be able to make at least the minimum payment on all your debts each month, but if you have to choose between the two types of debt, it's a good idea to focus on secured debts first. Yes, this means you'll start accruing a lot more interest on your unsecured debts, but that's likely better than losing your car or the roof over your head.
If you've already made your regular monthly payments and you're wondering what to do with your extra cash, consider putting it toward your unsecured debts. By paying these off early, you'll significantly reduce the amount of interest you pay over the lifetime of the loan.
For example, say you have $2,000 of debt on a credit card with a 20% interest rate. If you pay $100 each month, it will take you a little over two years to pay off the loan, and you'll end up spending an extra $453 in interest. If you bump your payments up to $150 per month, you're now looking at a 16-month repayment period, and you'll only pay $281 in interest.
It's important to understand what kinds of debts you have so that you can formulate the best strategy for repaying them. But the best strategy of all is to avoid taking on more debt than you can afford to pay back. Then you won't put yourself in danger of losing your assets or being charged outrageous interest fees.
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