Essentially, unsecured debt is any financial obligation that is not backed by collateral. Credit cards, student loans, medical bills and store charge accounts are all examples of unsecured debt as they are supported only by the borrower’s promise to pay. Car loans, mortgages and the like are considered secured because a lender can force the sale of the items for which the loans were written to recoup any losses they might suffer if a borrower does not meet the terms of the loan agreement.
With that in mind, here are some things you should know about unsecured debt.
Higher Interest Rates
Unsecured debt, because it represents more of a risk to a lender usually imposes higher interest rates. With no asset to fall back upon with which to be made whole, lenders charge more in interest payments to help offset that risk. Now, with that said, some borrowers can get better interest rates than others because they are perceived to be more creditworthy. This determination is made based upon credit scores.
The Role of Credit Scores
Borrowers whose scores fall into the “good’ or “excellent” categories will typically be called upon to pay less for an unsecured loan than those whose scores are considered “fair” or “poor”.
According to FICO, scores ranging from 850 to 740 are considered excellent. Those ranging from 739 to 670 are considered good. Scores falling in the 669 to 580 range are considered fair, while 579 or less is considered a poor credit score. Credit scores are based upon data recorded by the three credit reporting bureaus; Experian, Equifax and TransUnion.
These companies are notified each time consumers apply for credit, make purchases on credit, or make payments on credit accounts. Missing monthly payments, applying for too much credit, or carrying balances higher than 30% of the total amount of credit available to consumers can lower their credit scores.
Borrowers whose scores fall into the fair category will find considerable difficulty in acquiring unsecured financing at reasonable rates. This is even more of an issue for potential borrowers whose scores are considered poor. In fact, those applicants are likely to find their requests denied altogether — unless they can find someone to co-sign their loans.
Defaulting on Unsecured Debt
While lenders do not have physical property to go after, they can seek legal remedies as a last resort. Before things get to that point however, they impose late fees and interest rate hikes to try to impress upon borrowers the seriousness of their intentions. Agents representing the creditors will also attempt to contact borrowers with the hopes of working out repayment plans.
In the event that all of these efforts fail, unsecured debts are usually sold to collection agencies. This action will trigger a significant drop in borrowers’ credit scores — in addition to the declines their ratings have already incurred owing to late payments. As indicated above, this will make it very difficult for those borrowers to find financing of any type in the future.
Moreover, many employers, insurance companies and landlords evaluate credit scores as part of their application review processes. Getting jobs, securing insurance or finding places to reside can be negatively impacted as a result.
But wait, there’s more.
Creditors can file suits in the courts when the terms of loan agreements have been breached. Should the courts find in their favor, wages and other sources of income can be subject to garnishment. While the laws vary in different states, certain personal assets can also be at risk for seizure.
In Summary
While unsecured loans are primarily granted based upon an applicant’s promise to pay, lenders have a number of remedies available to them should the loans go unpaid. It is important for borrowers to have a solid plan for repaying debts before accepting unsecured loans— or any loan for that matter.
