How does secured and unsecured credit affect your finances?Not all debt or credit is the same. While this might seem like an obvious statement, it’s important to note because different types of credit generally require different repayment strategies. On a similar note, not all types of credit are accessible to everyone, and understanding why requires you to know what you’re looking at when you consider a certain type of credit. In this post, we’re comparing secured and unsecured credit, two terms that you will come across as you seek out credit opportunities. Continue reading to learn more about both types of credit and how they relate to your finances.

Defining secured and unsecured credit

Secured credit

The word “unsecured” implies that there is a way of making credit secure. As such, it might be easier to first talk about secured credit. When lenders offer secured credit options, they’re allowing consumers to borrow in a way that doesn’t leave the lender completely unable to recoup potential losses. That’s because secured credit typically requires the borrower to provide a form of collateral to be held by the lender until the debt has been repaid. In some instances, consumers must pay a deposit up front before being eligible for certain types of secured credit — this is true of secured credit cards, for example. In others, debts are secured by the lender’s right to seize borrowers’ assets upon default. This is best illustrated by home equity lines of credit (HELOC), as a lender can foreclose on a home if a borrower stops making payments.

Unsecured credit

Once you have a decent understanding of secured credit, unsecured credit should start making sense. Unlike secured credit, unsecured credit doesn’t require deposits or collateral; the lender simply grants credit based on a borrower’s credit health. Individuals with clean credit reports and good credit scores typically get access to better interest rates, cooler perks and even higher credit limits.

How do they differ?

Credit cards are the most common form of unsecured credit and also come in secured forms, making them a great illustration of the differences between secured and unsecured credit. For instance, if you’ve ever wondered why credit card APRs tend to be higher than mortgage rates, it’s because the lack of collateral for credit card borrowers means more risk for the lender. To compensate, the borrower usually pays more in interest. However, as stated above, individuals with healthy credit are seen as a “good” risk to lenders and rewarded appropriately with lower interest rates. Conversely, there’s little flexibility in the rates that borrowers pay for with secured options like credit-builder loans and secured credit cards, with the interest rates on these sometimes being higher than those of regular credit cards or loans.

Secured credit is also limited in that the total amount of credit available to you — your credit limit — sometimes will be much smaller than what’s offered to those applying for unsecured credit. This might seem counterintuitive, but remember that good credit health is a solid indicator to lenders that a borrower is trustworthy and thus deserving of greater credit access. This is the key reason why people with bad credit tend to have trouble accessing unsecured credit in any form. In the rare cases where these individuals are eligible for unsecured credit, they’ll likely be paying exorbitantly high interest rates.

There are, of course, exceptions to these limitations, as not all secured credit is created equally. For example, most mortgages and auto loans, along with HELOCs as mentioned above, are secured forms of lending that aren’t necessarily restrictive to borrowers. In fact, for purchases like a house or a car, secured borrowing might be preferred because the value of the asset being purchased with the loan can be used to help pay off the debt in the instance of default. Additionally, secured loans of this nature may also provide lower interest rates than any unsecured counterparts.

Do secured and unsecured credit affect your credit scores differently?

While secured and unsecured credit seem different, the short answer to whether they affect your credit differently is no. If a lender reports debt repayment to the credit bureaus, then that payment, be it secured or unsecured, will affect your credit in the same manner. That’s why, regardless of what type of borrower you are, if you have trouble making repayments on a debt, you will want to contact your lender as soon as possible to discuss your options.

Why would you want one type of credit over the other?

The choice between one type of credit over the other is largely going to be situational, since there are not only differences between secured and unsecured credit, but between various types of secured credit as well. For lower-credit individuals, secured credit in the form of credit-builder loans or secured credit cards is often ideal because access to traditional sources of unsecured credit will be restricted. Comparatively, loans and credit lines like mortgages and HELOCs can be useful for individuals who’d rather use collateral to lower their interest and help pay off debts if they ever default.

Unsecured credit is usually ideal for those looking for higher credit limits without any upfront costs or the forfeiting of assets in default. Additionally, unsecured credit can confer a number of unique benefits, like rewards in the case of credit cards or even the ability to negotiate your interest rates. Overall, there’s generally a greater degree of flexibility afforded by unsecured credit, especially when it comes to credit cards. However, secured credit cards afford people with poor or limited credit the opportunity to borrow and build their credit, which will allow them to access the extra benefits and flexibility of unsecured cards in the future.

Navigating the world of credit doesn’t have to be challenging. For more credit and financial advice, keep reading our personal finance blog.