The Difference Between Secured and Unsecured Debt
Debt always involves a measure of risk. Lenders try to assess and understand that risk by taking into account certain factors, such as the income of the borrower, their track record of paying off other debts, how much they are asking for, and for what purpose. Other information, such as their age, occupation, level of education and employment history are also considered. The primary question that the lender needs to answer is: how likely is this person to repay the loaned amount?
There are two possible answers: not really, or likely enough.
Banks and other financial institutions have immense experience in assessing applications for credit. That experience is assisted by sophisticated software that integrates thousands of records into the assessment process. But sometimes, the question cannot be answered satisfactorily by either option. The lender is then unable to issue a straight rejection or approval of the application. In such instances, in order to safeguard themselves against the inherent risk in the loan, they will insist on security (collateral) to cover the secured debt if non-payment arises. Unsecured debt, on the other hand, has no such security.
People should not regard a request for security as somehow demeaning or prejudicial. It is a standard practice in any credit industry. The secured debt has the security attached to it simply as an unofficial form of insurance against non-payment. Unsecured debt does not have this added feature and is more hazardous to the lending institution. If the borrower defaults, the bank is legally allowed to expropriate the security. Secured debt is therefore safer. Unsecured debt represents a total loss to the lender if the debtor absconds.
Secured debt can potentially have any asset as its security. Some examples are:
- residential property or other real estate
- industrial equipment
- investment products
- shares in a business
- any other valuable item such as art, jewellery or precious metals
- a large cash reserve
Bankers are notoriously negotiable people and there is no limit on what they may accept as security.
Type of finance
Secured and unsecured debts are more often encountered in respective sectors of the credit industry. Their disparate natures make them suitable for different lending situations.
Secured debt is usually associated with:
- home mortgages
- motor finance
- large-scale money loans for a specific purpose
Unsecured debt is most commonly seen in these situations:
- credit cards
- short-term personal loans (such as payday loans)
- student loans
Terms of the loan
Obviously, because the security affects the risk involved in the loan, lenders offer different terms based on its presence or absence. Secured and unsecured debts can be compared on the basis of the usual factors.
Interest: lenders determine the interest rate in response to the perceived risk. The higher the risk the more interest they will charge. It is no surprise that secured debt typically has a lower interest rate than unsecured debt.
Amount: lenders are unlikely to trust anyone with a large sum on an unsecured basis; the larger the sum lent, the more they stand to lose if something goes wrong. Unsecured debts are seldom (if ever) as large as secured debts.
Duration: the extensive contract periods of mortgages and vehicle loans are harder to obtain for unsecured debts. The length of time that the lender has to commit themselves to increases the risk that they are taking. Secured debts are often very long term, such as the examples given above.
Provider: large lending institutions like banks usually provide the community with secured debt on expensive assets or to people who require substantial amounts of money. Unsecured debt is granted by smaller companies or payday lenders. Banks do provide small-scale finance but they are much harder to obtain it from.
Generally speaking, lenders have to safeguard themselves against risk. This may mean declining an application entirely or asking for security. Secured debt is not only about risk, however. The provision of security is also a statement by the borrower that they are serious about the transaction and that they are properly committed to settling the loan, since losing the security is the risk that they, in turn, are taking.
This principle of shared risk is absent in unsecured debt. The trade-off is that it is easier to obtain, but only for shorter periods and at much higher interest rates.