Secured vs unsecured debt - How do they affect your finances?
All debts are not the same and their effect on your finances are also not similar. Both are different. If you want to do well in your financial life, then you need to know the difference between secured and unsecured debts properly. In this article, we will talk about it. So without wasting any more time, let’s start discussing the topic straight away.
Unsecured debts - High-interest rate but there is no collateral
Unsecured debts are not tied to an asset. Typical examples of unsecured debts include credit cards, student loans, payday loans, medical bills, etc. If you default on your credit card payments, then the creditor can’t foreclose your property. But the creditor can take the following steps to get back his money:
- The creditor may hire a debt collector to force you to pay off unsecured debt.
- The creditor can file a lawsuit against you to garnish your wages or impose a lien on your property.
- The creditor can report the delinquent account on your credit report so that you’re forced to pay it off.
Negative listings make a negative impact on your credit score. You would obviously want to avoid that.
Interest rates on unsecured debts
The interest rates on unsecured debts are usually high. The national average interest rate on a credit card is 15.96%. But this is not the complete story. The average APR on a credit card depends on the type of card you have chosen. Usually, the interest rate varies between 15% and 24%.
Typically, the interest rate on student loan varies between 5.05% and 7.60%. Here’s how much you have to pay for different types of federal student loans.
- Direct subsidized loans - 5.05% interest rate
- Direct unsubsidized loans for undergrads - 5.05% interest rate
- Direct unsubsidized loans for grad students - 6.60% interest rate
- Direct PLUS loans - 7.60% interest rate
The interest rate on the payday loans is very high. The APR on a payday loan can be as high as 500%. This is probably why so many people are in payday loan debt at this moment.
How to pay off unsecured debts
Let’s find out how you can pay off different types of unsecured debts in various ways:
1. Credit card debt: You can use a credit card debt settlement program to pay off your debts. The settlement company can help to cut down your outstanding balance by more than 50%. The bankruptcy option is also open for you.
2. Payday loan debt: You can consolidate your payday loans to lower your interest rates and get an affordable repayment plan. Just check out the state payday loan laws to avoid paying interest rates to illegal lenders.
3. Student loans: You can use the federal student loan repayment plans like Income-Based Repayment Plan (IBR). Income-Contingent Repayment Plan (ICR), Income-Sensitive Repayment Plan, Standard Repayment Plan, Extended Repayment Plan, Graduated Repayment Plan, etc. The bankruptcy option won’t help you in this case. However, if you can pass the Brunner Test, you may be able to discharge your student loans through bankruptcy.
You can crack the Brunner Test under the following circumstances:
You have tried your best to pay off student loans.
You can’t afford a minimum standard of living if you’re compelled to pay off student loans.
Your current financial situation is not good.
Your present financial situation is less likely to improve during the major part of the repayment period.
Secured debts - Low-interest but tied to an asset
Secured debts are linked to some type of assets that you own. Typical examples of secured debts are mortgage and auto loan. The interest rate on a 30-year fixed rate mortgage is 4.75%, which is less than what you pay for credit cards and payday loans. Let’s look at the current mortgage and refinance rates:
- 30-year fixed rate VA - 4.5%
- 20-year fixed rate mortgage - 4.625%
- 15-year fixed rate mortgage - 4.250%
The average interest rate for the auto loan is 4.21% on 60-month loans. This is again much less than the average interest rate on a payday loan or credit cards.
Lenders charge low-interest rate due to the low-risk factor. If you default on an auto loan or a mortgage loan, your assets will be forfeited. Lenders will foreclose your properties. So they’re less likely to incur any loss.
In case of a mortgage, the lender will foreclose the property in the event of loan default. He will try to sell your property in an auction to the highest bidder. If the selling price of the property doesn’t cover the debt, then the lender may ask you to pay the deficit balance.
Always remember, you don’t own the asset tied to the secured debt till the loan has eliminated.
In a nutshell,
- These debts are not tied to an asset
- You won’t lose any asset
- The interest rate is high
- Examples: credit cards, payday loans, student loans, medical bills, etc.
- These debts are tied to an asset
- You may lose your asset
- The interest rate is low
- Examples: mortgage and auto loan
Secured debts are a good choice since they have low-interest rates. But they also have risks. You may lose the asset in the future. So be careful. If you have both secured and unsecured debts, then try to get rid of home loans or auto loans first. Make minimum payments on the unsecured debts to avoid lawsuits. If you can’t pay off unsecured debts, then get the help of a debt relief program.