What is unsecured debt? | bank rate
If you have a student loan, medical bill, credit card, or personal loan, you have unsecured debt.
Unsecured debt is any debt that is not backed by collateral. Unlike a home mortgage or car loan, where the property could be repossessed if you default on payment, there is nothing associated with unsecured debt. Simply put, a lender cannot repossess or foreclose on an asset you own.
Since the debt is not linked to an asset, it is more risky for the lender. To compensate for this risk, lenders usually charge higher interest rates. The interest rate on your unsecured debt depends on your credit rating. You qualify for the best interest rates if your credit rating is good to very good.
Taking on this form of debt is common. As long as you know how to properly manage your debt, you can use unsecured debt to secure your financial future.
Unsecured debt vs. secured debt
Unlike unsecured debt, secured debt has an asset attached to it. Two of the most common forms of secured debt are mortgages and auto loans. If you fail to pay those debts, a lender can mortgage your home or repossess your vehicle.
|Unsecured Debt||Secured Debt|
|medical bills||home loan|
|credit cards||car loan|
|Personal Loans||Secured line of credit|
Because secured loans involve assets, lenders typically charge lower interest rates. For example, while they are similar products in terms of loan amounts and repayment terms, secured home equity loans have an average interest rate of 5.78 percent, while unsecured personal loans have an average interest rate of 11.88 percent.
However, both secured and unsecured debt affect your credit score. If you miss a payment, it can be reported to the three major credit bureaus: TransUnion, Experian, and Equifax.
|Unsecured Debt||Secured Debt|
|interest rate||Usually higher||Usually lower|
|Consequences of late payment||Lower credit rating||Lowered credit rating and repossession of seized assets|
|Obtain a title after loan repayment||no||Yes|
Examples of unsecured debt
Some common forms of unsecured debt are credit cards, student loans, and personal loans. If you default on your student loan, your property will not be taken – nothing has been put up as security.
Although lenders typically charge higher interest rates on unsecured debt, there are ways around this. For example, you may qualify for a 0 percent introductory rate on a credit card. Another way to avoid the higher interest rates would be to pay off your credit card bill in full each month.
What happens if you fail to pay an unsecured debt?
Although a lender cannot initially take your assets if you fail to pay an unsecured debt, you must expect other consequences. First, you will be charged late payment fees. And if you don’t make a payment for too long, your unsecured claim will be sent to a collection agency.
Once your debt is sent to the collection agency, your credit score goes down because payment history accounts for 35 percent of your score. This will make it difficult for you to successfully get loans in the future.
Depending on what type of unsecured loan you have, your wages may be garnished if you don’t pay off your debt. A creditor can also sue you in court and establish a lien on your property. If a court awards the lender a judgment, your assets could be at risk. Laws vary from state to state as to what personal assets are exempt from confiscation.
How to get rid of unsecured debt
When dealing with unsecured debt, there are two main options: pay off the debt or file for bankruptcy.
There are several possible ways to pay off the debt. If you’re able to reduce your spending elsewhere, you can shift your finances to pay off debt faster, using more of your expendable or unrestricted income to pay off debt. If that’s not financially viable, you may need to refinance your unsecured debt. To do this, contact your lender and set new terms on the loan that lower your monthly payments or interest rate.
You can also apply for a debt consolidation loan to replace old debt with new debt, usually at a lower interest rate. However, these loans are not always beneficial to you and can negatively affect your credit score as they close multiple accounts while creating new debt.
If paying off the debt is not an option for you due to financial problems, you may need to file for bankruptcy. There are several bankruptcy options, including Chapter 7 and Chapter 13, that you must choose based on your financial situation.
If you file for Chapter 7 bankruptcy, your unsecured debt will be largely wiped out in a few months — although your credit score will be significantly affected and your bankruptcy will remain on your credit score for up to 10 years. When you file for Chapter 13 bankruptcy, you agree to pay off a portion of your outstanding debt over a period of three to five years, after which the remaining debt will be paid off.
It’s worth noting that student loans are unlikely to be forgiven if you file for bankruptcy.
The final result
With unsecured loans, there is no risk of your assets being confiscated unless the court awards a judgment to the lender. However, it’s still important to understand the consequences of not paying your unsecured debt. To avoid late fees and serious damage to your credit score, create a plan to pay off your unsecured debt before applying.