Understand the key differences and learn how to pay off each type of debt.
April 9, 2019 – By Geoff Williams
If you are trying to dig yourself out of debt or you’re about to take a loan, you’ll want to know the difference between secured and unsecured debts to create a well-laid-out repayment plan. Understanding the type of debt you’re dealing with is especially important to determine which debts to pay off first if you’re on a strict budget. Read on to learn more about the basics of secured versus unsecured debt, and what you need to know about how unsecured debt is collected and ways to create a sound debt-payoff plan.
What is Secured Debt?
Secured debts are protected by an asset. For instance, a car, an RV or a house would be considered a secured debt. If you are delinquent and stop making your auto loan or mortgage payments on time, your home could be foreclosed or repossessed by your lender.
What is Unsecured Debt?
Unsecured debts can include student loans, medical bills, payday loans and credit card debt. Unlike with secured debts, lenders cannot collect your assets if you do not pay the debt you owe, but they can report your delinquent payment to negatively impact your credit score or take you to court to garnish your wages.
What Happens if You Don’t Pay Your Debt?
Don’t ignore your debt, advises Katie Ross, education and development manager at American Consumer Credit Counseling, headquartered in Newtown, Massachusetts. “All those bills piling up need to be addressed, and the longer you wait, the messier and more complicated your debt issue becomes,” she says.
For instance, if you have secured debt, such as your house, car, boat or motorcycle, and you stop making payments, a lender could put a lien on the asset. The lender would then track you down if you stopped making payments. With a house, you would likely experience a foreclosure, where the deed goes back to the lender, and you would wind up being forced to move out and sell your home.
If you neglect to pay off unsecured debt, it’s unlikely your possessions would be reclaimed by a lender. But if you stop making payments, you may be hounded by debt collectors calling, emailing and texting you to try and convince you to pay the debt down. If you’re behind on credit card payments, you can also expect to receive late fees and see your interest rates climb. If you’re late with payments, just as your interest rate rises, your credit score will start to drop, making it harder to borrow more money in the future. You could also be sued by your lender and, if you don’t start on a plan to make payments through monthly installments, you could have your wages garnished.
How to Pay Off Debt if You’re on a Tight Budget
If your credit score hasn’t tanked yet, you might want to consider refinancing your mortgage or your car loan so that you can get a lower interest rate or a smaller monthly payment. The main downside: In the long run, for that financial relief, you could end up paying more than you would have over the life span of the loan. It’s also important to pay secured debt on time. There’s nothing wrong with having secured debt, especially for an asset such as a home or a car. But if you’re struggling to pay for things, and you have a boat or an RV you can’t afford to pay off, you may want to sell them to pay off the debt.
With unsecured debt, experts generally favor the snowball or avalanche approach. Ross explains the strategies this way: “Debt avalanche focuses on paying debts in order of highest interest rate and debt snowball focuses on paying the smallest balance first, while making minimum payments on the larger debts.” You still continue to make minimum payments on debts each month, she adds.
Phillip Dickson, the co-CEO of Vimvest Advisors, a wealth management and financial planning firm in Sarasota, Florida, is a proponent of the debt snowball method, though the math often favors the debt avalanche approach. “If you’re overwhelmed with unsecured debt, like credit cards, (it’s) a simple solution,” Dickson says, referring to the debt snowball strategy.
“Let’s say you have three credit cards totaling $1,500, $2,500 and $5,000. First, you need to determine a budget that works for your situation, so that you can make minimum payments on all three cards. Then, once the smaller credit card is paid off, you take the same payment and add it to the second-largest credit card,” Dickson says.
After the second card is paid off, Dickson suggests combining the two payments into the third credit card. “Before you know it, you’ll have all your credit cards paid off. It creates a calculated snowball effect that helps build momentum while staying on budget. Of course, this may vary depending on your situation.”
Others prefer the debt avalanche method, which focuses on the payments with the highest interest rate. It can be dispiriting for some, because progress can seem slow, but if you’re paying attention to your credit card statements and aren’t using your credit cards to accrue more debt, you should fairly quickly start to see that you’re making headway on what you owe.
Regardless of which debt repayment strategy you employ, the key is systematically paying it down. Keep in mind, the money going toward your debt isn’t going toward your savings account, your retirement or your child’s college fund. To avoid feeling insecure and take control of your finances, assess which approach is the right fit for you and hold yourself accountable.