Key takeaways

  • Unsecured debt doesn’t require you to offer collateral, such as a vehicle or a home, to secure the loan.
  • Because unsecured debt is riskier for lenders, interest rates are typically higher, and approval requirements are more stringent. 
  • Personal loans, credit cards and student loans are common types of unsecured debt.
  • To get rid of unsecured debt, you’ll have to pay it off or consider bankruptcy to discharge your debts.

When you take out a loan or other type of financing, you’ll typically have two options: secured or unsecured debt. The key difference is whether or not you need to put up collateral — like your home or vehicle — to protect the lender in case you fail to repay the loan. 

Unsecured debt is any debt that isn’t backed by collateral. Since no asset can be seized if you default, it’s riskier for the lender. Lenders usually charge higher interest rates for unsecured debt vs. secured debt to compensate for this risk. 

Unsecured debt is a common option for many borrowers. When managed responsibly, it can be a useful tool for achieving financial goals without risking assets.

Unsecured debt vs. secured debt

Since secured debt creates less risk for lenders, it’s often associated with lower interest rates and more favorable loan terms. However, your property is at risk if you default on the loan. 

On the other hand, unsecured debt doesn’t require you to put any assets on the line. This offers more flexibility, particularly if you don’t have assets to offer as collateral. However, lenders typically mitigate the risk by requiring higher minimum credit scores and charging higher interest rates. 

For example, while they’re similar in loan amounts and repayment terms, home equity loans typically offer significantly lower rates than personal loans. 

Both secured and unsecured debt affect your credit. If you miss a payment, it may be reported to the three major credit bureaus, TransUnion, Experian and Equifax. This, in turn, can cause your credit score to drop. Negative marks from missed payments can also stay on your credit report for up to seven years.

Unsecured debt Secured debt
Asset attached No Yes
Interest rate Typically higher Typically lower
Consequences of defaulting Lowered credit score, fees, debts sent to collections Lowered credit score, fees, repossession of asset
Given a title after repaying the loan No Yes

Examples of unsecured debt 

Credit cards and most personal loans are the most common types of unsecured debt. Although lenders typically charge higher interest rates on these types of debt, there are strategies you can use to lessen the financial burden.

For instance, you may qualify for a credit card introductory rate of 0 percent. Credit cards typically do not charge interest if you pay off your balance each month. Personal loans also often offer lower rates for those with excellent credit and steady income. 

Examples of secured debt 

Common types of secured debts include auto loans, mortgages, home equity loans and home equity lines of credit (HELOCs). 

Since auto loans are backed by your vehicle, the lender can repossess it if you default. When it comes to mortgages, home equity loans and home equity lines of credit, defaulting puts you at risk of foreclosure. 

In some cases, you can use other valuable assets like boats or jewelry as collateral, adding flexibility but still carrying the risk of repossession if you fail to meet your obligations.

What happens if you don’t pay an unsecured debt

While a lender can’t immediately take your assets if you fail to pay an unsecured debt, there are still potentially serious consequences depending on the circumstances of the loan: 

  • Collections: If the debt remains unpaid for too long, it may be sent to a collection agency. Even if you pay off the debt quickly, an account going to collections can stay on your credit reports for seven years.
  • Credit score: Your credit score will suffer since payment history accounts for 35 percent of it. This will make it harder for you to get approved for future loans.
  • Fees: You’ll likely incur late fees for missed payments. 
  • Garnishment: Depending on your loan type, your wages might be subject to garnishment if you fail to repay your debt. 
  • Lawsuits: A creditor might also sue you in court and place a lien against your property. If a court awards a judgment to the lender, your assets may be at risk. State laws vary, so some personal assets may be protected from seizure.

How to get rid of unsecured debt

There are generally two main options for dealing with unsecured debt: pay it off or file for bankruptcy. 

Option 1: Pay off the debt

Depending on your income, goals and overall financial situation, there are several potential paths you can take to pay off your debt: 

  • Rework your budget: If you can reduce your expenses elsewhere, you can shift your finances to pay down the debt faster by dedicating more of your expendable or unassigned income to eliminating the debt.
  • Consolidate your debt: You can also seek a debt consolidation loan to replace old debt with new debt, typically at a lower interest rate. However, these loans are not always beneficial. If you close multiple accounts during the process or spend more on those credit cards, this will also adversely affect your credit. It’s best to leave accounts like credit cards open even after you pay them off with the debt consolidation loan to mitigate effects on your credit.
  • Request hardship assistance: Many lenders offer hardship programs. These programs can sometimes help you get temporarily lowered interest rates, payment pauses, reduced minimum payments, waived late fees or due date extensions for a short time. This may help you get caught up again on your payments if you are behind.

Option 2: File for bankruptcy

If paying back the debt is not an option, you may need to consider filing for bankruptcy. There are two common types of bankruptcy for individuals: Chapter 7 and Chapter 13.

  • Chapter 7 bankruptcy: This allows for the discharge of most, if not all, of your unsecured debts, so you won’t be required to repay them. The process typically takes a few months to complete, but it comes with significant long-term consequences, including a major impact on your credit score and a bankruptcy mark on your credit report for up to 10 years. However, it may also allow you to begin to rebuild credit sooner than if you continued to try to repay an impossible debt.
  • Chapter 13 bankruptcy: This involves creating a repayment plan to pay back a portion of your debt over a three- to five-year period. After completing the repayment plan, you may be able to have your remaining unsecured debt discharged. While Chapter 13 doesn’t provide the immediate relief of Chapter 7, it allows you to keep your assets and may have a slightly less severe impact on your credit.

Before deciding on bankruptcy, it’s important to consult with a bankruptcy attorney to fully understand the implications and determine if it’s the best course of action for your situation.

The bottom line

Unsecured debt can be a useful financial tool, offering the financing you need without putting your assets on the line. However, due to the increased risk for lenders, it typically comes with higher interest rates and more stringent qualification requirements. 

If you’re managing unsecured debt, it’s important to stay on top of payments and explore strategies to minimize the impact of higher interest rates. Consider setting up a plan to pay off your unsecured debt or consult with a financial advisor to explore your options. Should your financial situation become overwhelming, you may consider debt consolidation or bankruptcy. 

Understanding your choices and taking proactive steps can help you manage your debt more effectively and work toward a healthier financial future.

Frequently asked questions

  • Although federal student loans are backed by the government, you aren’t required to put up collateral to get approved for these loans. The same goes for private student loans. For this reason, both of these fall into the unsecured debt category.
  • Yes, you can convert unsecured debt into secured debt through debt consolidation. For example, you could take out a secured loan, such as a home equity loan, to pay off your unsecured debts. This can potentially lower your interest rates, but it also puts your collateral at risk if you’re unable to make payments.
  • Each situation is different. However, you might have too much unsecured debt if your debt-to-income (DTI) ratio, which compares your monthly debt payments to your gross monthly income, is above 36 percent. This may indicate that you are overextended and could have difficulty managing additional debt.

    If you’re struggling to meet your monthly payments or have more debts than liabilities, consider reducing your outstanding debt balances.

Read the full article here

Subscribe to our newsletter to get the latest updates directly to your inbox

Multiple Choice
Share.
Exit mobile version