Although there are many types of loans available, when it comes down it, there are two main types of debt: secured vs. unsecured debt. Whether a debt is secured or not determines what a creditor can do if you are unable to make payments on it. It also determines the interest rate you will be charged for that debt.
When a lender loans you money, that lender is taking a risk on you. Even if you have a great credit score, there is always a chance that your circumstances will change and you won’t be able to pay as agreed. Lenders have several ways to protect themselves. One way is to give you a secured debt. Typically, with a secured debt, the property or item you are purchasing with the loan acts as collateral, securing that debt. If you don’t pay back the loan as agreed, the lender has the right to the property as payment of the debt. Examples of secured debts included home mortgages, car loans, boat or other vehicle loans and specific secured credit cards.
With an unsecured debt, there is no collateral, and the lender doesn’t have the right to claim any items you purchased with the borrowed money. Unsecured debts include things like personal loans from a bank, credit cards, medical debt, store cards and student loan debt.
Lenders want to protect themselves in some way when they provide unsecured loans. That’s why most credit cards and personal loans have higher interest rates than secured loans, such as mortgages and car payments. In an ideal world, you’ll be able to pay off the balance on your credit cards in full each month. If that doesn’t happen, the lender benefits by receiving additional payments from you in the form of high interest.
Secured debts aren’t without their risks to the borrower, either. Although they might have lower interest rates than credit cards, the stakes can be higher if you become unable to pay. In the case of a home loan — either a mortgage or a home equity loan — you can end up losing your home if you can no longer make the monthly payments.
The type of debt you have plays a part in determining your credit score. The variety of credit you have or don’t have makes up 10 percent of your Fair Isaac Corporation (FICO) score. Having a mix of credit is generally considered a good thing, especially if you don’t have a particularly long credit history. Generally, having a lot of credit cards in the mix and not a lot of secured debt isn’t looked on favorably. People who rely on credit cards are often seen as a higher credit risk, especially if they start missing payments.
Don’t feel compelled to apply for a range of loans to boost your credit score, though. What matters more than the type of debt you have is your payment history and the total amount you owe. When it comes to getting on top of your debt and developing a healthy financial life, learning about the different types of debt is just one part of the process.
If you are experiencing financial difficulty and are looking for a solution, non-profit credit counseling can help you make sense of all your options. Contact us today for a free financial assessment with one of our certified credit counselors.
Consumer Education Services, Inc. (CESI) is a non-profit service provider of comprehensive personal financial education and solutions for all life stages and for all of life’s milestones. Our goal is enhanced economic security for everyone we serve.
CESI is NOT A LOAN COMPANY