Not all debt is equal. Unsecured debt is a very particular kind of debt that has a specific set of rules and definitions surrounding it. Understanding what makes unsecured debt unique is vital to upping your financial acumen.
What’s the definition of unsecured debt? How does it differ from secured debt? What happens if you can’t pay back your unsecured debt? Having the answers to these questions is the first step to freeing yourself from debt.
Definition of Unsecured Debt
Unsecured debt is any debt supported only by your creditworthiness. With unsecured debt, you don’t put up collateral or any type of asset to back up the debt. Instead, the creditor looks at your credit score and credit history, along with other indicators of your creditworthiness, and determines it can be reasonably be sure you’ll pay off your debt. Instead of asking for collateral, the lender merely asks for your signature on the paperwork, thus the name, “signature loans.”
Secured vs. Unsecured Debt
The major difference between unsecured debt and secured debt is the presence of collateral. With an unsecured debt, no collateral is necessary to receive the loan; the lender offers you the loan based on your creditworthiness alone.
With secured debt, it is necessary for you to put up some form of collateral in order to receive the loan. By definition, collateral can be almost anything, as long as it holds sufficient value in the event the bank has to resell it to recoup some of its money. It doesn’t necessarily need to cover the entire value of the loan.
For most personal loans, the most common form of collateral is your home or your car. These items are generally the most valuable possessions a person owns, thus they are the items put up first by consumers in an attempt to secure funding.
Secured and unsecured debts are also typically on offer to different types of borrowers. Lenders are more likely to offer secured debt to borrowers with lower credit scores, since the presence of collateral makes the loan less risky for the bank. Unsecured debt, meanwhile, is typically for borrowers with high credit ratings and a history of paying debts on time.
Common Forms of Unsecured Debt
Many of the most common forms of debt are unsecured debt. You might not even think of them as potential sources of debt.
Credit cards are the most common form of unsecured debt, totaling around $779 billion and $16,748 per household on average in the U.S. alone. Since credit cards have such high interest rates (which often only get higher if you miss payments), they can also be one of the hardest forms of unsecured debt to get out of.
Personal and business loans can also be unsecured under the right circumstances. Personal loans for most purposes are unsecured and based on your credit history, while many business credit lines are unsecured (and lifesavers for businesses in need).
Student loans are generally unsecured, especially private student loans. After all, there isn’t anything obvious that the bank can take as collateral for your private student loan; it’s not as if it can somehow seize and resell your education.
Medical debts are usually unsecured debt, depending on how you handle them. Medical debts can be extremely difficult to deal with. After all, it’s not like falling ill or suffering an injury is a personal choice, as so many debt-incurring activities are.
Many of your bills, if left unpaid, will become unsecured debt as well. Rent, phone bills, and utility bills all become unsecured debt if you don’t keep up with your payments. That’s not to say that there aren’t serious consequences if you fall delinquent on these bills; as you could face eviction or have your phone and utilities shut off. However, your creditors won’t be able to seize any of your assets.
Pros and Cons of Unsecured Debt
All debts have their upsides and their downsides (although, if you’re struggling with your debts, it can all seem negative). However, unsecured debt has a few unique pros and cons that are worth mentioning.
Pros of Unsecured Debt
The two major upsides of unsecured debt are obvious if you understand the concept: you don’t have the risk of losing your collateral, and you’re likely to have much simpler application process.
No Collateral
With unsecured debt, you aren’t risking losing a major piece of collateral, such as your car or your home, if you fail to make payments. That’s not to say that there aren’t risks with delinquent or refused repayment. You could tank your credit score and make it next to impossible to access credit in the future if you don’t take your unsecured debts seriously. However, at least you won’t be homeless as a (direct) result.
Easier Application Process
From banks to credit cards and more, there are many different ways to seek unsecured debt if you need a loan. When you don’t have to tackle the problem of collateral, gaining approval and receiving your loan can be much, much simpler.
Cons of Unsecured Debt
A loan without the need for collateral sounds appealing, but unsecured debt has its fair share of downsides, too. Namely, it can be harder to get, and the payout might end up being less than the alternative.
Harder to Get
Without collateral to soften the risk of lending, most creditors are choosier about who they offer unsecured debt to. If you don’t have a stellar credit score and credit history, it can be hard to find an unsecured loan with decent terms.
Less Money at Higher Interest Rates
The higher the amount of money you need, the less likely a lender will be to offer you unsecured debt. As the amount that you’re borrowing rises, so does the lender’s risk in lending to you. If that number gets too high, the lender is likely to ask for collateral to back the debt up, making it a secured debt.
For similar reasons, unsecured debt often comes at higher interest rates to cover the increased risk of lending. That means that, with unsecured debt, you often end up paying more to the lender than you would with a secured loan.
Why Do Creditors Offer Unsecured Debt?
If a creditor could offer only secured loans and demand collateral in return, why wouldn’t it? After all, if every loan had collateral associated with it, lenders would take on much less risk in offering loans.
The short, simple answer is that, in many cases, unsecured debt is more profitable for lenders despite the additional risk. People are often more willing to take on unsecured debt since it can be easier to get and doesn’t put their property at risk, which increases the volume of loans that a lender can offer. Beyond that, unsecured debt often carries higher interest rates, increasing the profitability of the loan despite the added risk.
How Do Creditors Assess Risk when Deciding Whether to Lend to You?
Creditors look at a wide variety of different criteria when determining whether to lend to you and whether to offer you a secured or unsecured loan, often summed up by the “five C’s” of credit: character, capacity, capital, collateral, and conditions.
Character
Lenders determine your character mostly by checking your credit history. Have you paid off your loans in a timely fashion in the past? Have you ever lapsed in your payments? Have you ever dealt with negative financial situations such as collections, judgments, bankruptcies, or foreclosures? All of these questions will likely factor in.
Capacity
Capacity here means your capacity to pay off the debt. Lenders weigh your income and job stability against your current level of debt and figure out if you will reliably be able to keep up with your payments.
Capital
Capital is how much capital you already have to put toward whatever you’re taking on debt to get. It’s not always a factor, especially with unsecured debt such as credit cards, which usually aren’t to finance any purchase in particular.
Collateral
If a secured loan, the presence of valuable collateral can make or break the approval. If the loan is unsecured, collateral obviously doesn’t really matter.
Conditions
The conditions of the loan can be almost anything. What is the loan going to be for? What interest rate and amount make sense for the lender? What’s acceptable to the borrower? All of these questions and more influence the form the loan takes, including whether it is secured or unsecured.
Which Type of Debt Should You Prioritize, Secured or Unsecured Debt?
First off, a warning: you should really try to avoid having to make this decision. Generally, most people trying to figure out which type of debt to prioritize are in danger of falling behind on their debts. Careful planning and sound financial decisions can often help you avoid this situation altogether.
If you do need to make this decision, though, understand that there isn’t a perfect answer. You should do what makes the most sense for you after carefully studying what’s at risk and weighing your options.
In general, though, the rule of thumb is that it usually makes sense to pay off secured debts before unsecured debts. While letting unsecured debts go late can be disastrous for your credit score, it’s generally preferable to losing your car or your home by playing fast and loose with your secured debts.
What Are the Unsecured Debt Limits for Different Types of Bankruptcy?
If you have too much debt, you are not eligible for some forms of bankruptcy (although there are sometimes ways around these limits depending on your individual situation).
For Chapter 13 bankruptcy, the limit for unsecured debt as of April 1, 2016 was $394,725. For Chapter 7 bankruptcy, there are no limits on unsecured debt.
What Happens to Unsecured Debt When You Die?
The regulations regarding what happens to your debt when you die depend on the type of debt you owe, as well as the terms of that debt.
Credit card debt, the most common form of unsecured debt, may still be due to the creditor if the original borrower passes away. The borrower’s estate can pay credit cards out of the assets left behind, but if those assets run out, lenders don’t usually have recourse to seek full repayment, since the debt has no collateral behind it. If there is a joint account holder on the card, or if the borrower lived in a state with certain laws regarding debt (called “community property states”), then the other account holder or the borrower’s spouse may inherit the debt.
Student loans have similar rules. The borrower’s estate should try to pay down private forms of student loan debt, but since there’s no collateral, lenders usually have no recourse if the estate runs out of assets. Some of the biggest private lenders have rules in place to forgive debt if the borrower passes away. As with credit cards, though, spouses who live in community property states will be responsible for the debt of the deceased borrower if the borrower took that debt on during the marriage.
What Are Your Options if You Can’t Handle Your Unsecured Debt on Your Own?
Your first course of action in repaying your debt should always be to repay it as intended. With smart budgeting and a little bit of financial discipline, paying down your debts might be possible (although it likely won’t be fun).
If the old-fashioned way of paying off your debts isn’t cutting it, though, you do have options, including debt consolidation. If you’re curious about how debt consolidation works and what you could expect from a reputable debt consolidation company, we invite you to read up on National Debt Relief. If you like what you see, give us a call and let us help you understand your debt options.