There are two types of debt: Secured, where a debt is tied to real property or accounts, and unsecured, which is debt that is not tied to any account.
The most common forms of secured debt are auto loans and mortgages. What this means is, if a borrower defaults on their mortgage, the bank can foreclose on the home. Same goes with missing car payments (only the car would be repossessed). These types of loan default remedies usually happen without involving the courts, as the foreclosure or repossession procedures are usually covered in the paperwork you sign when you close on the loan.
Unsecured creditors do not have the right to seize a debtor’s property if the debtor defaults on the loan. In most cases, unsecured debt is credit card debt: If the debtor defaults, the debt is charged off and the charge off is recorded on the debtor’s credit report, causing complications with getting a loan or line of credit in the future. (If this has happened to you, you can see your free credit report summary, updated every 30 days, on Credit.com to see how it affected you.)
In addition to credit cards, other kinds of unsecured loans include signature loans, business lines of credit and private student loans; these types of loan agreements are approved based on the person’s credit alone. Unpaid bills — such as cellphone, utility and medical — or missed apartment lease payments can also be seen as unsecured debt.
Typically, these types of debts remain in their original categories. It’s important to note, however, that it is possible for unsecured debt to become secured and vice versa.
How a Debt Changes Status
One way a debt can change status from unsecured to secured is as the result of a lawsuit. In some cases, the bank (or a collection agency that buys or is assigned the debt) may take you to court to try and recover its money if you default on a loan or credit card. If the lawsuit is successful, the court enters a judgment against you in favor of the bank or collection agency. A judgment is a powerful tool: Once a creditor has a judgment entered, they can seize funds, put a lien against your house and garnish your wages. In this way, your unsecured debt becomes secured — and the security is your assets.
Your debt can also change from secured to unsecured debt. If you have a foreclosed home that is sold for less than what is owed on the mortgage, the difference between the sales price and the mortgage is called a deficiency balance and, depending on your state’s laws, you may still be responsible for paying this deficiency off. This mortgage deficiency will no longer be secured as the home is no longer attached.
Similarly, “if a car is repossessed, but at auction, fails to fetch enough to pay off the outstanding loan, the difference is an unsecured debt that can be collected,” Mike Bovee, founder of Consumer Recovery Network, said. “Auto repossessions that result in a deficiency balance are quite common.”
Whether a mortgage deficiency or auto deficiency, if you are sued, the debt can turn into a secured debt once again if the creditor is able to win a judgment against you in court. “It does not be come a secured debt unless it is perfected in a lien,” Steve Rhode, a consumer debt expert, said. “A judgment is a legal ruling that a debt is owed and it can be cleared with bankruptcy. If it is converted to a lien and then recorded against the property, it is secured by the property. In my experience, most judgments don’t become liens.”
Another way debt can change status is when someone uses a home equity loan or cash out refinance to pay off their unsecured credit card debt. In doing so, “they might get some perks like a potential tax deduction for paying off the debt but they also have just turned it into an anchor if they want to deal with the debt in a number of ways,” Rhode said. “Someone may have a lot of unsecured credit card debt and gets a mailer from their bank about how awesome a home equity loan can be. The bank is trying to sell the loan. The consumer says it sounds wonderful and leaps.”
Preventing Unwanted Change
In heading off the change of status from unsecured to secured debt by way of a lawsuit, you do have a number of options, including the following.
- Pay Off the Debt: “You will ideally want to negotiate debts before they even reach an attorney for collection, and that includes paying or settling the balance owed after a repossession,” Bovee said.
- Fight the Lawsuit: Your options for dealing with a lawsuit include making them prove what you owe, raising the statute of limitations as a defense, or suing them back. Simply responding to the suit can be enough to stop it (if you raise the statute of limitations defense in the response, for example), while ignoring the suit will result in automatic victory for the creditor.
- Settle the Debt: Sometimes the creditor will agree to take far less than what is owed on a debt and consider it paid in full. If you go this route, make sure you get documentation to prove this is the agreement.
- File Bankruptcy: “If you cannot see a clear path to resolving unpaid debts, and things have escalated to the courts, you can also look to bankruptcy to wipe the slate clean (even get rid of existing judgments),” Bovee said. Bankruptcy is an extreme remedy, though, as this can drop your credit score immensely and can stay on your credit report for up to ten years.