The difference between secured and unsecured debts is the presence or absence of collateral.
To secure a debt certificate, this simply means that in the event of default, the buyer’s assets are used to repay the lender’s investment.
Common types of secured debts are mortgages and car loans. When a person or company takes out a mortgage, the property in question is used to substantiate the repayment guarantee. If the individual or company fails to repay the mortgage as agreed, the bank has the right to seize the property. The same applies to car loans. If the conditions of the loan are not met, the issuing entity acquires ownership of the vehicle.
The risk of default on secured debt, called the counterparty risk for the lender, is relatively low, because the borrower has so much to lose by neglecting his financial obligation.
Conversely, unsecured debt does not have such collateral. If the borrower defaults on this type of debt, the lender must file a lawsuit to collect the debt.
Because the investment is only covered by the reliability and credit of the issuing entity, the unsecured debt carries a higher level of risk than its counterparty. Because the risk for the lender is greater than that of secured debt, the interest on unsecured debt is often correspondingly higher.
However, the interest on various debt instruments is largely dependent on the reliability of the issuing entity. An unsecured loan to a person can bear astronomical interest rates because of the high risk of default, while government-issued treasury paper (another common type of unsecured debt instrument) has much lower interest rates. Despite the fact that investors are unable to claim government assets, the government has the power to save extra dollars or levy taxes to pay off its liabilities, making these types of debt instruments virtually risk-free.