Debt seems to be a way of life in America. Credit cards, student loans, vehicle notes, furniture loans, personal loans, etc. These creditors define the financial lives of many Americans. Some debts are secured, others are unsecured. Many don’t realize the difference between secured and unsecured debts. So let’s discuss it.
While there are many types of debts, such as the ones I mentioned above, they generally boil down to two essential categories: secured and unsecured.
Secured debts favor the lender. Unsecured debts are more favorable for the consumer. Let’s break down each of these types of debts, including the potential consequences of not paying them back.
What is a Secured Debt?
Simply put, a secured debt is any financial obligation that has an underlying asset connected to it. This is referred to as the collateral.
The most common type of secured debt that consumers have is a financed vehicle. Businesses also often have secured debts for things like equipment, inventory, or farm products.
There are two elements to a secured debt. One is the promissory note—our promise to pay back the borrowed amount plus interest. The other is a security interest, which grants the lender certain rights if the borrower defaults on the loan.
In a secured transaction, there are three parties: secured party, obligor, and the debtor. (Hopefully your secured lender isn’t Wells Fargo!).
The secured party is the lender and acquires certain rights in the collateral upon signing a secured financing agreement. The obligor owes the money to the secured party. The debtor puts up the collateral that secures the loan.
The obligor and the debtor are usually the same person, but this isn’t required.
Vehicle loans, furniture loans, and financed electronic devices are all examples of secured debts. A secured credit card has a specific amount of cash held in escrow that the credit card issuer may take if the borrower does not timely repay. The mortgage on your house is also a secured debt.
Enforcing Secured Debts
The most effective means of enforcing an obligation on a secured debt is a repossession/foreclosure. This is a process by which the lender takes back the collateral as a way of meeting the debtor’s financial obligation.
All 50 states have adopted a body of law called the Uniform Commercial Code. There are certain processes laid out in it allowing the secured party to take the collateral without having to first file a lawsuit. The law expressly authorizes this “self-help” remedy, as long as there is no breach of the peace.
A vehicle repossession is a self-help remedy. The lender (secured party) may repossess the vehicle upon default. This can include falling behind on payments, failing to maintain proper insurance, or using the vehicle in a way prohibited by the financing agreement.
Someone I know recently dealt with a repossession. She walked out to her car only to find that the lender repossessed it. Due to some difficult life circumstances, she fell behind on payments. The lender had no second thoughts about repossessing the vehicle.
The towing company took the vehicle to a repo lot. But it wasn’t there long.
By the time she got there, only 24 hours later, the car was already on its way to an auction house. And that was on the other side of the state.
She was able to get the money together to cover the deficiency and repossession fees. But it was an absolute nightmare to deal with. This is the threat that looms with secured debts.
In short: if you don’t pay back, creditors can take your stuff fairly easily.
What is an Unsecured Debt?
While secured debts have collateral attached to the financial obligation, unsecured debts do not. These debts are simply promissory notes, credit card agreements, student loans, and the like.
Personal loans are unsecured debt. Credit cards are unsecured debt (unless they are secured, as noted above). Student loans are unsecured debt.
Anything that does not have some physical asset attached to it is an unsecured debt.
This type of debt is a bit more favorable to consumers. Whereas secured debts have self-help remedies by law, unsecured debts require more effort to enforce.
Enforcing Unsecured Debt
Unlike with secured debts, unsecured debts offer lenders no self-help remedy. So, if you fall behind on a credit card payment, they cannot just go and take money from your bank account or take your stuff. (Though I will nuance that in a moment).
The general rule with unsecured debts is that a creditor must bring you to court and obtain a judgment before it can use a remedy at law. Here’s what that may look like.
A few years ago, three different creditors sued one of my clients. These were credit cards that had gone to collections. The lender hired a law firm and had a summons sent to my client for the amount owed plus interest, penalties, and late fees.
Thankfully, my client was able to settle these out of court. But if the lawsuit proceeded and the creditors won, they would have obtained a judgment against my client. But that’s not the end of the story.
The creditors then have to perfect the judgment (usually recording with the county clerk) and then pursue another action in court for a remedy. Three common collection remedies are a bank levy, wage garnishment, or judicial lien on real estate.
Three Remedies for Unsecured Debt Judgments
A bank levy is a legal action that freezes funds in your account and allows the creditor to take money from it. If there is a levy on your account, you will not be able to use the amount the levy is for.
A garnishment is a direct collection from the wages at your job. The creditor takes the garnishment order and files it with your employer. The employer must send a portion of your paycheck to the creditor by law.
A portion of your earnings are not subject to garnishment by law, though, in order to ensure debtors can still cover their basic bills.
In Tennessee, the following formula sets garnishment limits:
(a) … The maximum part of the aggregate disposable earnings of an individual for any workweek which is subjected to garnishment may not exceed:
(1) Twenty-five percent (25%) of the disposable earnings for that week; or
(2) The amount by which the disposable earnings for that week exceed thirty (30) times the federal minimum hourly wage at the time the earnings for any pay period become due and payable, whichever is less.
(b) In the case of earnings for any pay period other than a week, an equivalent amount shall be in effect.
Tenn. Code Ann. § 26-2-106.
A judicial lien on real estate subjects your property to the debt until satisfied (paid off). A judicial lien is a legal “encumbrance” that can hinder your ability to sell your house. If you sell your house, before you can transfer title and receive any equity, a portion of the sales price goes to satisfy the lien amount.
Three Exceptions For Unsecured Debts
The above remedies apply generally to unsecured debts. But there are three types of unsecured debts that can skip these usual limitations: federal student loans, back taxes, and child support.
It is very important to stay current on these three kinds of debt if you have them. Otherwise, they can obtain a bank levy or wage garnishment without having to sue you first and get a judgment.
Don’t play chance with these types of obligations!
Final Thoughts on Secured and Unsecured Debts
Creditors have various remedies at law if we fail to pay them back. Secured debts involve a fairly efficient means for the lender to protect their interests. Unsecured debts are more drawn out. But creditors will certainly bring lawsuits to recover what debtors owe.
The best way to deal with these financial threats is to avoid them entirely. But if you still have secured and unsecured debts, the next best way is to power through them as quickly as possible.
I advise using the debt snowball method, but also lay out some other strategies here. Find a plan that resonates with you and follow through on it.
Helping Millennial professionals power through their debt to achieve financial freedom is my passion. If you’re ready to have a professional guide you to the place you want to be, then book your free Discovery Session with me now!