Loans and other financing methods available to consumers fall under two main categories: secured and unsecured debt. The difference between two is the presence or absence of collateral – that is, backing for the debt, something to be taken as security against non-repayment.
Secured debts are those in which the borrower, along with a promise to repay, puts up some asset as surety for the loan. For a debt instrument to be secured simply means that in the event of default, this asset can be used by the lender to repay the funds it has advanced the borrower.
Common types of secured debt are mortgages and auto loans, in which the item being financed becomes the collateral for the financing. With a car loan, if the borrower fails to make timely payments, the loan issuer eventually acquires ownership of the vehicle. When an individual or business takes out a mortgage, the property in question is used to back the repayment terms; in fact, the lending institution maintains equity (financial interest) in the property until the mortgage is paid off in full. If the borrower defaults on the payments, the lender can seize the property and sell it to recoup the funds owed.
The risk of default on secured debt, called the counterparty risk to the lender, tends to be relatively low since the borrower has so much more to lose by neglecting his financial obligation. So secured debt financing is typically easier for most consumers to obtain. As this type of loan carries less risk for the lender, interest rates are usually lower for a secured loan.
Lenders often require the asset be maintained or insured under certain specifications to maintain its value. For example, a home mortgage lender often requires the borrower to take out homeowner's insurance. By protecting the property, the policy secures the asset's worth for the lender. For the same reason, a lender who issues an auto loan requires certain insurance coverage so that in the event the vehicle is involved in a crash, the bank can still recover most, if not all, of the outstanding loan balance.
Conversely, unsecured debt has no collateral backing: It requires no security, as its name implies. If the borrower defaults on this type of debt the lender must initiate a lawsuit to collect what is owed.
Lenders issue funds in an unsecured loan based solely on the borrower's creditworthiness and promise to repay. Therefore, banks typically charge a higher interest rate on these so-called signature loans. Also, credit score and debt-to-income requirements are usually stricter for these types of loans, and they are only made available to the most credible borrowers.
Outside of loans from a bank, examples of unsecured debts include medical bills, certain retail installment contracts such as gym or tanning-club memberships and the outstanding balances on your credit cards. When you acquire a piece of plastic, the credit card company is essentially issuing you a line of credit with no collateral requirements. But it charges hefty interest rates to justify the risk.
Because one's investment in them is backed only by the reliability and credit of the issuing entity, an unsecured debt instrument like a bond carries a higher level of risk than its asset-backed counterpart. Because the risk to the lender is increased relative to that of secured debt, interest rates on unsecured debt tend to be correspondingly higher.
However, the rate of interest on various debt instruments is largely dependent on the reliability of the issuing entity. An unsecured loan to an individual may carry astronomical interest rates because of the high risk of default, while government-issued Treasury bills (another common type of unsecured debt instrument) have much lower interest rates. Despite the fact that investors have no claim on government assets, the government has the power to mint additional dollars or raise taxes to pay off its obligations, making this kind of debt instrument virtually risk-free.