People learn many different things in school when they’re growing up. Some of those things end up being super useful. After all, you wouldn’t get too far in life if you couldn’t read, after all. We memorize some things, forget them, and never need them again. Most of us don’t find ourselves grappling with quadratic equations on a daily basis.
Despite all of this education, though, there are some things barely taught in schools despite the fact that they’re extremely necessary for living a normal life. Financial literacy is one of those things.
Because of this lack of financial education, people end up turning to Google to answer their questions about finance, debt, and other topics. Here’s one question that we see searched all the time:
What’s the difference between unsecured and secured debt consolidation?
It’s an important question. Despite the fact that secured and unsecured debt consolidation sound like they’d be similar things, there are huge differences that you should be aware of if you’re researching your debt consolidation options. Choosing debt consolidation can be a life-changing decision, and you should make sure you have all necessary information before you sign any paperwork.
So, what is the difference between secured and unsecured debt consolidation? First, let’s define what each of these terms actually means.
What is secured debt consolidation?
When you’re talking about secured debt consolidation, you’re likely talking about a personal loan that you take out from a bank or other lending institution. You use that loan to pay off all your various different debts at once, and then focus on paying down the loan. Ideally, you’ll end up paying less overall on your debt while getting out of debt faster than you would otherwise.
With a secured debt consolidation loan, you give the lender “security” for the lent sum by putting up a major asset as collateral. If for some reason you’re unable to keep up with the payments on your loan, then the lender can legally seize that collateral and recoup some of its losses.
What the lender accepts as collateral can vary widely. Collateral does not have to be valued at the value of the loan; it can be worth less or more, and lenders tend to be conservative with their valuations. Most of the time, with secured debt consolidation, lenders ask for major assets such as your home or your car as collateral. If you can’t keep up with your payments, you don’t just end up in financial hot water, you might end up losing your house or your vehicle as well.
Other forms of collateral might be acceptable too, including everything from jewelry to land and other types of sellable assets. The easier that collateral would be to repossess and sell at a fair price, the more attractive that collateral will be to a lender.
Why do lenders ask for collateral for secured debt consolidation? Collateral helps lenders minimize the risk they’re taking on by lending to you. Above all, lenders want to be “made whole” when they lend, making their money back (and then some), no matter what. Being able to repossess and sell your collateral ensures that the lender will at least get something out of the deal.
That said; lenders don’t really want to seize your collateral if they don’t have to. Seizing collateral is a royal headache for everyone involved, and lenders aren’t set up well to repossess and resell assets. They’d much rather collect your money.
What is unsecured debt consolidation?
With unsecured debt consolidation, you have the same basic situation as secured debt consolidation. You’re working with a lender to get a personal loan that will allow you to pay off all of your various creditors at once. You then focus on paying off the loan.
With unsecured debt consolidation, though, you are not required to put up any sort of collateral in order to get the loan. You receive offers for these “signature loans” when the lender is relatively certain that you’ll be able to keep up with your payments. You just sign the paperwork and that’s that.
What’s the difference between secured debt consolidation and unsecured debt consolidation?
On paper, it seems like the difference between secured debt consolidation and unsecured debt consolidation is obvious: collateral. However, there are other, deeper differences between the two different types of debt consolidation loans.
One major difference is in interest rates. Unsecured debt consolidation loans tend to have higher interest rates than secured debt consolidation loans do. These higher interest rates stem from the fact that the lender is taking on more risk when offering you an unsecured loan. The higher interest rates are their way of hedging their bets and making they’re getting good value from the loan.
Another major difference is that unsecured debt consolidation loans can be much more difficult to get than secured debt consolidation loans. That makes sense when you think about it. After all, with an unsecured loan, the lender makes the decision to trust you to make your payments on time. That’s not a decision typically taken lightly.
So, how do lenders evaluate whether to offer you a secured or unsecured debt consolidation loan? Let’s dig into some common ways lenders judge potential borrowers.
How do lenders decide whether to offer secured or unsecured debt consolidation loans?
Lenders evaluate potential borrowers on a number of different criteria. The main factor for most lenders is the borrower’s creditworthiness, often summed up with a few categories known as the “Five C’s.” While lenders don’t actually have a creditworthiness grading rubric based on the Five C’s, you can be certain that they’ll have all five categories in mind when determining your creditworthiness. The Five C’s are as follows:
Character, as it relates to creditworthiness, means the quality of your character as a borrower. Can you be trusted to reliably manage your money and keep up with your payments? Does your credit score indicate a history of responsible borrowing? Or, has it taken a hit due to an inability to keep up with a lender in the past? In general, do you have a history of accountability and frugality? All of these questions are important to a lender trying to get a sense of your character.
To a lender, capacity means your capacity to keep up with your loan payments. Most commonly, lenders judge capacity by looking at your debt-to-income ratio. How much debt do you currently have, and how much of your income each month goes towards paying it off? A higher debt-to-income ratio is common for people who are seeking debt consolidations loans, but it can also be a red flag to a wary lender trying to evaluate the risks of lending.
Capital here does not just mean how much money you have in your bank account. It includes savings, investments, and major assets. Lenders like to see higher amounts of capital for a variety of reasons, but the main one is that if you have a large amount of capital, you’ll be able to keep up with your loan payments even if you suddenly lose your job or source of income.
The assets that you could conceivably put up as collateral are important to lenders for most types of loans. When the lender is trying to figure out whether to offer a secured or unsecured loan (or whether it should offer you a loan at all), it might ask what assets you could put up as collateral if you had to. Chances are, though, that you won’t have that discussion until after the lender has decided to offer you a secured loan anyway.
What conditions led you to seek a debt consolidation loan? Was it irresponsible spending on credit cards? Did you need to finance an emergency medical procedure for yourself or a family member? What will you do differently to ensure that you don’t fall into debt again if approved for the loan? Understanding your circumstances through questions like these is vital for a lender to get a handle on your creditworthiness as a whole.
The Five C’s are just a rule of thumb, but they can be helpful to consider. These criteria help lenders not only decide whether to offer you a secured or unsecured loan, but also help lenders set your interest rates or decide whether to lend to you at all.
What should you pay off first: secured or unsecured debt?
Sometimes, individuals who are in a lot of debt and spending a large portion of their income on keeping up with their debt payments have to make difficult decisions about which payments to focus on first. While the right decision is usually dependent on their individual context and situation, people often want to know whether they should focus on paying down their secured debt or unsecured debt first.
This decision is almost entirely dependent on just how dire your financial situation is. If you’re struggling to keep up with all of your loan payments on time and need choose which payments you should make on time, then it’s likely smarter to pay down your secured debt first. After all, secured debt is tied to major collateral, such as your home or car. You can’t afford to lose those things, especially not if you’re already struggling financially. Falling behind on unsecured debt can be disastrous for your credit score, but at least it’s not going to ruin your life immediately.
If you’re not struggling financially, then the opposite might be true. Perhaps you’re trying to decide which debt you should prioritize paying extra on so that you can get out of debt quicker than you would just by making minimum payments. In this case, it might make more sense to target one of your unsecured debts first. Unsecured debts, after all, tend to have much higher interest rates than secured debts do. By eliminating unsecured debts first, you might stand to save a lot of money in the end in interest payments.
All of that said; there’s no single right answer for whether you should pay off your secured or unsecured debts first. The best advice we can give would be to take stock of your overall financial situation and make the best decision you can in the short term. Then, start budgeting and strategizing so that you never have to make that kind of difficult, no-win financial decision again.
Are there other debt consolidation options aside from secured and unsecured loans?
Personal loans are definitely the most common form of debt consolidation, but they’re far from the only ways you can consolidate your debt and take control of your financial future. Other types of debt consolidation, such as balance transfer credit cards, debt settlement savings accounts, and credit counseling can be wise alternatives to personal loans.
If you’d like to explore all your debt consolidation options and figure out what the right course of action is for you, look at the services National Debt Relief offers or just give us a call. We’d be happy to walk through your options with you and help you to find a solution to your debt problems. We’ve helped many people in need of advice on how to deal with their debt figure out their finances and get their lives back. Just check out our reviews and see for yourself!