What are secured and unsecured debts?
Nov 18th, 2021 | By FCT
For many Canadians, debt is a constant consideration. Decreased consumption during the height of COVID-19 lockdowns led to households paying down their unsecured debt at record levels. As Canadians continue to navigate these financial decisions, it’s important to understand the different types of debt.
What is secured debt?
A secured debt is “secured” by a piece of collateral—an asset like a home or car, or even the borrower’s savings. Often, the collateral to secure the debt is the asset the borrower is purchasing. A mortgage is a good example of this kind of debt. Unlike other forms of collateral, the asset that guarantees a secured debt is not handed over to the lender. Instead, the borrower gives the lender the right to take that asset if they are unable to repay the debt.
Advantages of secured debt
Because assets back a secured debt, the lender will consider it a safer bet and offer higher loan amounts at lower interest rates. Many types of secured debt also offer flexibility around the terms of the loan, so you can set out a path to repayment that works for you.
Drawbacks of secured debt
The asset used as collateral is always significant—a vehicle, portion of savings, a home—and its loss can be devastating if the borrower falls behind on their payments. Lenders also often require borrowers to maintain the collateral asset, and may even require the purchase of insurance to protect it.
What is unsecured debt?
An unsecured debt is one a lender offers with no need to put up an asset as collateral. Credit cards are the most obvious and common example, but lines of credit and even student loans are forms of unsecured debt. With no asset tied to the loan, the lender’s only recourse if their borrower defaults is a lawsuit or recovery services. This makes unsecured loans riskier for lenders, which means much higher interest rates.
Advantages of unsecured debt
Since the lender has no claim to their assets, the consequences of the borrower defaulting on the debt are lower than with most secured debts. Some forms of unsecured debt, like student loans can be considered “positive debts,” with the potential to increase a borrower’s wealth in the long run.
Drawbacks of unsecured debt
Because of the increased risk to the lender, they are only willing to offer smaller unsecured loans at higher rates. Large interest payments can make it difficult for some borrowers to pay down the principal of the debt, leaving them indebted longer than they expected, and limiting the amount of income that can go toward their savings or other long-term investments.
Managing secured and unsecured debt
The record-high debt servicing described at the beginning of this article was targeted towards unsecured debt. Staying focused on paying the principal of a debt, not just covering its interest is the key to being debt-free sooner.
For many unsecured debts, this means taking advantage of unexpected income or decreases in living costs, or consolidating high-interest debts into a single line of credit with lower interest or monthly payments.
For secured debts, especially mortgages, it’s always worth considering whether refinancing will benefit you. Never hesitate to consult a financial professional about solutions to help manage your debt.