You can classify debt into two categories: secured vs unsecured debt. While both types share similarities, there are also important distinctions. The primary difference is that secured loans require collateral, while unsecured loans don’t. This characteristic makes secured debt riskier than unsecured debt, as the lender can seize the asset if the borrower defaults.
In this brief guide, we’ll explore how both types of debts work and how they differ, so you understand the benefits and risks of each. Understanding the differences will help you make informed decisions about borrowing and managing your finances.
What is Secured Debt?
Secured debt is tied to an asset, which serves as collateral for the debt. That means if you fail to make payments, the lender has the right to take possession of the collateral to recover their loss. The presence of collateral reduces the risk for lenders, often resulting in lower interest rates for you as the borrower.
Examples of secured debt
Below are some examples of secured debts you’re likely to encounter:
Mortgage. This is the most common type of secured debt. When you obtain a mortgage, your home acts as collateral for the loan until you pay off the balance in full. Mortgages come with fixed and variable rates; terms can last 25 years or more.
Car loan. When you take out an auto loan, your vehicle acts as collateral for the balance. Most auto loans in Canada range from one to seven years and are readily available in Canada, even to those with poor credit. Car loan interest rates are generally fixed.
Secured credit card. A secured credit card requires a cash deposit, which functions as both the collateral and your credit limit. Secured credit cards are beneficial for establishing a credit history or improving your credit score. They can also help you rebuild your credit after bankruptcy.
Home equity loan. A home equity loan (also known as a second mortgage) allows you to borrow money against the equity in your home. You get access to a lump sum of money, which you must repay in fixed amounts over a specific period. As with a mortgage, your home functions as collateral for the loan. The interest rate is usually fixed.
Home equity line of credit (HELOC). A HELOC allows you to borrow money through your home’s equity, much like a home equity loan. The difference is that you can access a line of credit rather than receiving a lump of cash upfront. You can withdraw money up to your credit limit for a specific period, usually 10 years. After that, you must begin repaying the balance. However, each month, you must repay the accrued interest. Most HELOCs come with variable interest rates.
What happens if you default on a secured loan?
If you default on a secured loan, your lender may seize the asset used as collateral. This process, known as repossession or foreclosure, can severely impact your credit score and financial stability.
For example, suppose you stop making payments on your mortgage in Ontario. In that case, your lender can foreclose on your home or initiate a power of sale. These legal processes grant your mortgage lender the right to recover the outstanding loan balance by selling your home.
For items like vehicles, lenders might repossess the asset without a court order in Ontario (known as a self-help remedy)
What is an unsecured loan?
Unlike secured debt, unsecured debt does not require any collateral. This type of debt is given based on your creditworthiness and promise to repay. Therefore, it generally carries higher interest rates than secured debt due to the increased risk for the lender.
Examples of unsecured debt
Here are some examples of unsecured debts you’re likely to encounter:
Credit card. A credit card is the most common type of unsecured debt – pretty much everyone has one. It’s a revolving credit product, meaning you borrow when you need to up to your credit limit. You’re free to spend the money as you like. Repayment terms are flexible; however, you must make minimum monthly payments to keep your account in good standing.
Student loan. Most student loans don’t require collateral, so they’re classified as unsecured debts. This feature applies to government student loans and those issued by banks and other private lenders.
Personal loan. You can use a personal loan for any purpose, like a credit card. However, personal loans offer less flexibility, as you receive the entire lump sum upfront and must adhere to a strict repayment schedule. Some personal loan lenders do ask for collateral, but most don’t, which is why this type of debt is considered unsecured.
Medical bill. Often unexpected, medical expenses not covered by insurance accumulate as unsecured debts.
Utility bill. Overdue payments for services like electricity, water, or internet become debts that do not involve collateral.
Payday loan. A payday loan is a short-term loan that charges high fees. This type of debt is typically used in emergencies where you need cash fast but have no other borrowing options. The lender expects you to repay the borrowed funds by your next paycheque, from which the name “payday loan” comes.
Unsecured line of credit. A line of credit gives you access to funds up to a specific limit without requiring collateral. This type of debt is helpful to cover short-term financial needs, such as paying for a home renovation. The interest on a line of credit fluctuates based on changes in your lender’s prime rate.
H3: What happens if you default on an unsecured loan?
Defaulting on an unsecured debt can lead to aggressive collection efforts by your lender. It will also have a significant negative impact on your credit score. Your lender may hire a collection agency to recover the debt or take legal action to garnish your wages. However, they cannot seize property without a court order since there’s no asset backing the debt.
Comparing Secured and Unsecured Debt
Here are the ways that secured debts differ from unsecured debts:
Collateral requirement. To qualify for a secured loan, you’ll need to pledge an asset as collateral to your lender. Depending on the loan type, this asset can be your home, car, savings account, insurance policy, future paycheque, or valuables like art and jewelry. In contrast, an unsecured loan doesn’t require any collateral – your ability to repay the balance is based on your creditworthiness.
Interest rate. Because the collateral provides greater security for the lender, interest rates on secured loans are usually lower than those on unsecured loans. This feature makes secured debt a much cheaper financing option.
Term length. Long-term loans pose more risk to lenders than short-term loans since there’s a greater chance the borrower defaults. However, this risk is lower if an asset functions as collateral, which is why terms on secured debts are longer than unsecured ones.
Credit score criteria. Typically, you’ll need a higher credit score to be eligible for an unsecured loan. In contrast, the credit score requirements for secured loans are lower as the lender can take possession and sell the asset to recoup their money.
Borrowing limit. Your borrowing power is usually higher if you take out a secured loan, especially a home equity loan or HELOC. The more valuable the asset backing the outstanding balance, the less risk there is for the lender.
Application process. The application process for a secured loan can be more drawn out than one for an unsecured loan. This is primarily due to the lender needing to obtain an appraisal of the asset acting as collateral.
Repayment flexibility. Unsecured debts like credit cards and lines of credit offer more flexible repayment terms than secured debts.
Discharge under bankruptcy. You cannot include secured debts in a bankruptcy – only unsecured debts are eligible for discharge. The same rule applies to a consumer proposal, an alternative debt relief program to bankruptcy.
Reducing unsecured debt through a consumer proposal
Are you struggling with unsecured debts and looking for a way to reduce your obligations? If so, a consumer proposal might be the solution that can help you reach this goal. A consumer proposal is a legally binding process that allows you to negotiate with your creditors to repay a portion of your unsecured debts. Under this debt-relief program, you can spread your payments over five years – and no interest will accrue on your balance.
At David Sklar & Associates, we can determine if you qualify for a consumer proposal. And if you do, we’ll guide you through the process from start to finish, helping you regain control of your money.
The bottom line on secured and unsecured debts
Both secured and unsecured debts can be helpful under the right circumstances. However, each has its benefits and drawbacks, and choosing the right one depends on your financial situation and goals. Consider the differences discussed in this article before applying for any loan, such as collateral requirements, interest rates, term lengths, and eligibility criteria.
For personalized advice on managing debt in Ontario, visit David Sklar & Associates or call 1-844-962-9200 for expert guidance tailored to your unique circumstances.
