You can classify debts as either secured or unsecured. What differentiates the two is whether or not the borrower is required to provide collateral in exchange for the loan.
Although the distinction is subtle, it has significant effects on the cost of the loan and the penalties for nonpayment.
Especially when deciding which loans to pay off first, keep the following distinctions in mind as you investigate various financing choices.
Unsecured Loan
In contrast, if you default on an unsecured loan, the lender will not have anything to fall back on. One’s creditworthiness is the sole determining factor in these loans.
Thus, they incur much higher interest rates from lending institutions. Always keep in mind that the risk involved in making a loan determines the interest rate.
In the case of an unsecured loan, the lender cannot take back any collateral in order to recuperate their losses in the event of a failure. There is only one course of action left for them to do, and that is to seek a judgment in court and then attempt to collect on it.
Having a negative judgment on your credit report is true. Creditors might take legal action, such wage garnishment, to collect on judgements against you. Most judgments, however, are never collected because creditors perceive them to be more of a burden than they are worth.
Unsecured Debts in Common
Loans are a common starting point for those who incur unsecured debt. Consider that unsecured loans often have higher interest rates but cheaper origination costs when comparing loan types. It’s not cheap to do a title search and record a lien on a property.
Credit Cards
In spite of the fact that secured credit cards, as described above, do need collateral, they are still very uncommon. Unsecured credit cards often have annual percentage rates (APRs) of 20% or higher and often incur annual fees.
Your credit limit is normally dependent on two risk indicators used by card companies: your income and credit history. People who have established credit histories and steady incomes are more likely to get approved for credit cards with desirable benefits, such as those that offer cash back, air miles, or other types of incentives. Think of that as justification enough to work on your credit score.
Personal Loans
Due to their riskiness, personal loans have far higher interest rates than secured loans like car loans and mortgages. Bankrate currently quotes an average interest rate for personal loans of 11.91%. Meanwhile, the average interest rate for a new auto loan was 5.01%, which was less than half of what it was for borrowers with excellent credit.
For me, the best approach to protect yourself from unexpected costs has always been to have a stash of unused, high-reward credit cards in my wallet. You may borrow as much as you need without worrying about prepayment penalties, and the interest rate is comparable to that of a personal loan. Avoid getting into this situation in the first place by paying off your bills as they come due rather than letting them accumulate and forcing you to contemplate a debt consolidation loan.
If you want to save money and develop wealth, you should avoid taking out personal loans and instead use savings or a credit card with rewards that you can pay off soon.
Student Loans
Student loans, in contrast to personal loans, have a specific goal: furthering one’s education.
There is a wide variety of student loan options available, including federal, state, and private loans, as well as subsidized and unsubsidized options. Loans typically do not need collateral from borrowers.
However, because the government frequently subsidizes such loans, the interest rates are kept artificially low. According to StudentAid.org, the current average interest rate on undergraduate student loans is only 2.75 percent.
Unsecured Business Loans
There are certain types of company loans that do not require collateral. There are still a lot of unsecured company loans out there, and they’re usually contingent on the owners’ personal credit in addition to the business’s credit history.
That’s why it’s not uncommon for interest rates on such loans to be rather high. A lower interest rate and less costs are to be expected with a better credit score, as is the case with any loan.
Medical & Other Bill Default Debts
Even if unpaid invoices aren’t technically loans, they nevertheless count as debt. This is true for any and all monthly expenses, such as those for utilities, a telephone, or even medical care. If payment is not made, the supplier of the service may file a lawsuit.
Maintaining sufficient health insurance might protect you from the sting of unexpectedly high medical costs. And depending on the total, you might be eligible for quick cash.
Which Debts Should I Pay Off First?
If you have many debts, you should prioritize paying them off first. In a way. The debt snowball and debt avalanche methods, the two most popular approaches to reducing debt, are both effective. The debt snowball strategy is paying off the loan with the smallest balance first and making only the minimum payment on any additional obligations.
Debts of progressively decreasing size are paid off beginning with the lowest and working up to the largest. Then move on to the next; as you pay off one loan, you’ll be free to put more of your monthly budget toward the next.
The debt avalanche approach is quite similar, with one key difference: rather of arranging your obligations in descending order of magnitude, you tackle the one with the highest interest rate first. You can theoretically reduce your interest costs. For many people, though, the psychological lift and sense of satisfaction that comes from paying off those early, minor loans is enough to reinforce the habit and keep them motivated to pay off their obligations rapidly.
I think it’s best to focus on the unsecured obligations first, regardless of the method you choose.
As was just said, the interest rates on unsecured obligations are often higher. If you want to avoid paying interest rates of 15% to 25% on consumer debt, you should prioritize paying off your credit card balances. In the meanwhile, don’t add to your consumer debt or you can find yourself stuck on a never-ending financial hamster wheel.
Don’t worry about paying off your secured loans till later. Generally speaking, it makes more sense to eliminate debts like school loans and car payments before tackling larger financial commitments like paying off a home early.
Because secured obligations, such as mortgages and vehicle loans, often have lower interest rates. If you have access to low secured debts like a mortgage at 3.5 percent and a vehicle loan at 5 percent, but can earn 10 percent on average from the stock market, investing is usually the better choice.
Even debt-averse financial expert Dave Ramsey recommends saving for retirement well in advance of paying off your house in his well-known Baby Steps. Focus on eliminating your unsecured debt first, as it will be difficult to amass money while being saddled with astronomical interest payments.
Bottom Line
Debts should be avoided wherever possible. However, you should be aware that not all debts are the same. There are loans that have a clear and useful purpose, such as a mortgage for purchasing a home rather than renting a similar property in the same market.
Then there are the charges from your most recent buying binge on your credit cards. Pay off your unsecured obligations with the debt snowball or debt avalanche approach right away. Conversely, your mortgage and car payment might be put lower on the to-do list.
