Unsecured vs Secured Debt Explained

Written by Preet Banerjee

Wednesday, June 29th, 2016

 

 

When we think of the word “debt," many of us see it as a catch-all term that simply means “you owe someone money." But not all debt is the same, and knowing some of the distinctions might help you manage your debt more efficiently.

For example, the distinction between “secured" and “unsecured" debt is an important one, because it can affect the rate of interest that you're charged on the money that you owe.

When a debt is “secured" it means that you have something of value attached to the money that you've borrowed. A car loan or a mortgage on a house are two good examples. From the perspective of the lender, they feel a bit more confident lending you money because if anything were to go wrong and you couldn't make your payments, there's a contractual tie to an asset that could be sold off to recover some or all of the money that you owe them. Since this reduces the risk of the lender not getting some or all of their money back, that reduced risk translates into a lower interest rate.

On the other hand, an “unsecured" debt is not backed by any assets of the borrower. The most common example of this would be credit card debt. If someone runs up a large credit card balance and suddenly becomes unable to make their payments, there's nothing that can be forced into sale or repossessed in order to cover the amount owing. Since there is more risk to the lender of not getting some or all of their money back, this translates into a higher interest rate to the borrower.

Here's where this distinction could save you some money. When you were still in school, or recently graduated, your bank may have offered you an unsecured line of credit. The interest rate on an unsecured line of credit is generally much less than the rates charged on credit cards, so when you're younger, it can be tempting to sign up for this unsecured line of credit.

Fast forward a few years, and many people still have them, but now they may also be homeowners. A few years after buying a home, you may have built up some equity, and it's possible to get a home equity line of credit. This is a secured line of credit, which will normally have a lower interest rate than an unsecured line of credit.

Now, there are many households that carry balances on their old, unsecured lines of credit and may not realize that they can lower the interest rate they pay on that debt by setting up a secured, home equity line of credit instead. By switching from an unsecured line of credit to a secured line of credit, you could lower the amount of interest you pay.

Paying down debt is one of the top priorities for Canadians, and reorganizing the way your debts are structured could help you to become debt-free, faster.

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