There are two general categories of debt: unsecured debt and secured debt. The difference is very important. Knowing the difference will help you recognize each type of debt and develop a smart debt repayment strategy when you have both secured and unsecured debts. Here is a closer look.
What makes a debt secured?
Debt is secured when the creditor takes a “security interest” in collateral. That sounds confusing, but the concept is very simple. For some types of debt, creditors want to be sure that they can get their money back without too much trouble if you do not pay them. They want the debt to be secure—meaning they want to be sure they can recover. Taking a security interest accomplishes this. How does the creditor take a security interest? For personal debts, the language creating the interest is often included in the contract that the borrower signs when purchasing the collateral.
That security interest gives the creditor rights to the collateral. Collateral is simply property that you pledge to give the creditor if you fail to pay the money you owe them. This can get fairly complicated for business debts. In the business setting, many types of property can be used as collateral—business inventory, machines and equipment, and even accounts receivable. But for personal debt, this tends to be much simpler. Usually, the collateral on a secured debt for personal use is the very property that you purchased with the loan you were given.
Two simple examples are mortgages and auto loans. Both are typically secured debts and the collateral is the house or the vehicle. When you take out an auto loan, you use that auto loan to purchase a car. The creditor who is making the auto loan to you will take a security interest in that same car. The car is the collateral. If you pay off your debt in full, the car will become yours. If you fail to pay, the creditor can exercise its rights and take the collateral back from you. You may be able to “redeem” (get the car back) before the creditor sells it. You will either have to pay the payments you missed or the full balance of the loan, depending on your agreement with the creditor and your state’s law.
If the collateral does not cover the debt owed (say, for example, that the car was only worth $5,000 but you owed $7,000), then the creditor can pursue a deficiency judgment against you to collect the rest.
To recap: a secured debt is a debt for which the creditor has a security interest in collateral, meaning the creditor has a right to take property to satisfy the debt.
What about unsecured debts?
An unsecured debt is a debt for which the creditor does not have a security interest in collateral, and the creditor is therefore not entitled to take property from you to satisfy that debt without a judgment.
Common types of unsecured debt are credit cards, medical bills, most personal loans, and student loans*. These debts help you do something (buy items, pay your doctor, get an education), but they are not backed by a specific asset. So if you fall behind and can’t pay, there is nothing the creditor can take without further legal action. To compel payment, the creditor has to sue you and get a judgment against you. Before that happens, the creditor can use other tactics, which can have negative financial impacts—like using debt collectors and reporting missed payments to the credit bureaus. So, you do not want to ignore a creditor just because they are unsecured. But you should keep in mind that their legal recourse is more limited than a secured creditor.
*Note: While student loans are unsecured, there are some important differences between student loans and other unsecured debts, such as the very limited availability of discharge in bankruptcy.
Why does this matter?
The major lesson here is that you should be aware of the difference between secured and unsecured debt, and keep in mind that you typically have more to lose with secured debt. This means that secured debt should generally be the top priority in your repayment strategy. However, that will not always be the case. Here are two quick examples, one of when you would probably want to prioritize your secured debt and one for when you may want to prioritize unsecured debt.