Secured vs. unsecured debt: Understanding the difference and its impact on interest rates
Debt (that is, borrowing money and promising to pay it back with interest) is a common financial tool for individuals, businesses, and even governments. Companies and governments issue bonds and other fixed-income securities to fund expenses, capital improvements, and other initiatives. Households borrow money in the form of mortgages, auto loans, student loans, credit cards, and personal loans to fund pretty much all facets of life.
Borrowing falls into two basic types: secured and unsecured.
- Secured debt (or secured credit) is backed by collateral—an asset—that can be seized if the borrower were to default.
- Unsecured debt isn’t tied to a specific asset, nor does it require collateral. But that means it’s riskier, so it’s associated with higher interest rates.
Here’s a deep dive into the differences between secured and unsecured debt, both at the macro level for companies and at the consumer level, and how securitization affects borrowing costs.
Key Points
- Secured debt is collateralized by an asset from the borrower and generally has a lower interest rate.
- Unsecured debt is not backed by collateral and usually carries a higher interest rate.
The big picture: Corporate and business debt
Companies rely on borrowing to finance their operations, product development, and investments. They can issue debt in the form of bonds, which may be secured or unsecured. Remember: Secured debt is backed by collateral. For a company, that can be an asset (real estate, machinery, or even intellectual property) that the company pledges as security in case of default. In contrast, unsecured debt—sometimes referred to as debenture—is not backed by any specific collateral.
The presence or absence of collateral in a company’s debt has a significant impact on the level of risk associated with the investment, which in turn affects the interest rates offered.
When a company issues secured debt, the lender has the right to seize and sell the collateral in case of default, which reduces the risk of nonpayment. As a result, secured debt is generally considered less risky, and lenders may offer lower interest rates to companies that issue secured debt.
In contrast, unsecured debt exposes lenders to higher risk, because there is no collateral to recover in case of default. To compensate, lenders may charge higher interest rates on unsecured debt.
Credit rating agencies play a crucial role in assessing the creditworthiness of companies and assigning bond ratings that reflect the associated risk. Companies with higher bond ratings may enjoy lower interest rates on their unsecured debt, while those with lower ratings may face higher borrowing costs.
Companies that have few financing options and/or may be at risk of default often turn to junk bonds to stay afloat.
When it’s personal: Consumer debt
At the consumer level, the concept of secured and unsecured debt is similar.
When individuals borrow money through credit cards or consumer loans, banks and other financial institutions may offer different interest rates based on whether the debt is collateralized or not. Collateralized debt is backed by an asset such as a house (in the case of your mortgage) or a car (in the case of an auto loan) that you pledge as security for the loan.
Just as with business debt, lenders have the right to seize and sell the collateral in case of default. This reduces the overall risk for the lender and allows them to offer more favorable borrowing terms in the form of lower interest rates.
If you fall behind on your debt payments, the lender can take legal action to seize the loan collateral. Examples include the repossession of a car or foreclosure on a home or property.
Unsecured consumer debt, such as personal loans, student loans, or credit card debt, is not backed by any specific collateral. This makes it riskier for lenders, because there is no asset to seize and sell in case of default. As a result, lenders may charge higher interest rates on unsecured debt.
The type of debt you can access and how much you’ll pay for it—the interest rate—depends heavily on your credit score. A lower score means you’ll be limited in the types of debt you can qualify for, and you’ll generally pay higher interest rates.
In other words, if you want to pay lower rates on secured debt, and you want a better chance of qualifying for unsecured debt, work to raise that credit score. It’s a sad fact of finance that the most vulnerable consumers (i.e., the ones who could benefit most from a low-interest line of credit) are the least likely to access it. Such consumers often fall victim to predatory loans and other high-interest products that leave them trapped in a cycle of debt.
The bottom line
Carefully consider the risks and benefits of secured and unsecured debt when borrowing money. Although collateralized debt may offer lower interest rates, it also comes with the risk of losing pledged assets in case of default. Unsecured debt may have higher interest rates, but it doesn’t require any collateral, which provides more flexibility and avoids the risk of losing assets.
And if you’re the one lending the money (e.g., buying a bond or other security), the risk/reward metrics are flipped. You get a lower rate on secured loans, but you have recourse in case of a default. An unsecured (or poorly collateralized) loan will pay a higher rate, but you could end up losing your entire investment.