What Is Unsecured Debt?
When lenders provide funding to borrowers, they have to consider their risks carefully. They must base their lending decisions on the likelihood that the loans will be repaid with interest.
Lender risk can be mitigated by asking the borrower to guarantee the loan with an asset. That asset may be your car, home or other property. This is the case with a secured loan such as your mortgage.
But not every borrower wants or needs to put up collateral for a loan. Your credit score and credit report may show you are responsible with money, so lenders may be willing to lend you funds without collateral. This is the case with unsecured debt such as a credit card.
Here’s everything you need to know about unsecured debt.
What is unsecured debt?
Debt that is unsecured is not tied to an asset such as a car or home. The only thing reassuring the lender that you will pay back the loan is your loan agreement and your record of repaying other loans. Because unsecured loans require nothing more than a signature, they are otherwise known as signature loans.
Secured debt, by contrast, is tied to some form of collateral, which the lender can seize if the borrower defaults on the debt. For example, if Joe neglects his car loan, the lender can take his car. If Mary stops making payments on her mortgage, the bank can repossess her house.
Because the bank is taking a risk by lending without collateral, unsecured loans tend to be smaller — from $500 to $50,000 — and for relatively short terms, from a few months to five years. They also come with higher rates than secured loans. Many lenders of unsecured loans prefer to set them up as fixed-rate and fixed-term loans.
Consider these pros and cons of unsecured debt:
|$5,000 across 3 credit cards with varying interest rates|
|No collateral needed to qualify||Good or excellent credit required to qualify|
|Lending can be flexible and as needed||Higher interest rates than secured loans|
|Funding can be used for education, personal needs, emergencies or debt consolidation||Terms tend to be short|
|Faster approval and less paperwork||Ease of borrowing can lead to overborrowing|
|Default does not risk any assets||Default can badly damage your credit score and lead to wage garnishment|
What types of debt are typically unsecured?
There are many types of unsecured loans, some for specific purposes and some without particular restrictions. Some of these types come with astronomically high rates and fees while others are reasonable and worth considering to help you reach your financial goals.
- Credit cards provide revolving credit to users at high interest rates. These are extremely common and are one of the most convenient and flexible forms of borrowing available.
- Personal loans are unsecured funds from a bank, credit union or online lender that can be used for a wide variety of uses, such as home repair, consolidating debt, funding special occasions or addressing emergencies.
- Student loans are for financing education and can be administered by a variety of lenders, including the federal government.
- Payday loans are short-term loans for small amounts — usually a few hundred dollars at most — with very high interest rates. These loans are usually due on the borrower’s next payday and can be predatory.
- A line of credit is another form of revolving credit, which means you are preapproved for a certain amount and can borrow flexibly as needed up to that amount. Some lines of credit are secured by assets such as houses or cars, but unsecured credit lines are also a
- Peer-to-peer loans are administered by online companies that act as intermediaries between individual investors and borrowers. These loans tend to be available to those who struggle to qualify for traditional personal loans.
- Small business loans fund the needs of small businesses such as operating expenses, inventory and systems upgrades. Small business loans may be secured to business assets or may be unsecured.
Who are these loans good for?
The short answer is that these loans are good for people with good or great credit. Those with mediocre or poor credit will have a difficult time securing most of these loans. Unsecured loans are also often favored by those who want money faster and with less hassle as they tend to have faster approvals and require less paperwork.
Those who can get unsecured personal loans can use them for just about anything they want. Borrowers often use this funding for expenses that arise during daily life, such as home improvements, special occasions, major purchases, medical bills, emergencies and educational expenses.
Debt consolidation is another common use for unsecured loans. Consolidating debts that have higher interest rates can help you bring down the total amount of interest you pay on all your debt combined.
Some types of unsecured loans, such as business loans and student loans, are intended for certain uses.
What are common eligibility requirements?
Eligibility for unsecured loans usually revolves around a borrower’s credit score and their debt-to-income ratio (DTI). Those who can qualify for these loans usually have good or great credit ratings since the lender needs to have an assurance of the borrower’s habit of repaying debts.
Your DTI is the percentage of your income that goes to servicing your debts compared to your total monthly income. You can calculate your DTI by dividing your monthly debt payments by your monthly gross income. Lenders tend to look favorably on DTIs of 35% or lower.
If your DTI is high, such as between 36% and 49%, lenders may examine your credit utilization rate and your credit history to see if you may be creditworthy.
Your credit utilization rate is the ratio of how much credit you use at a given time to how much credit you have access to. Lenders are looking for a credit utilization rate of 30% or lower, as this indicates that you limit your own use of credit to a level that is manageable for you.
Your credit history is the record of how you’ve serviced your debts in the past. This history, on which your credit score is based, tells a story about your approach to borrowing and repayment. If you haven’t borrowed much in the past and have a lean credit history, lenders might balk at this lack of information. Building up your credit history can be done in a variety of ways, including methods with low barriers to entry such as using credit cards and establishing merchant accounts with major retailers.
If you aren’t able to qualify for a loan based on these factors, one option might be to recruit a cosigner, which is someone who puts their signature on the loan along with yours, attesting that they will assist in making sure the loans get serviced properly. Close friends and family members with good credit are usually cosigners. They are taking on a lot of risk by backing the borrower, so a good relationship and strong motivation are essential. The lender will assess the cosigner’s credit history and credit score, which may boost your chances of qualifying for a loan, particularly one with favorable terms.
Who gives these loans?
Unsecured debt can come from a variety of sources, ranging from traditional lenders such as banks and credit unions to online companies. Which lender you work with will depend on what kind of loan you are looking for, what type of credit you have, how quickly you want the funding and the type of lenders with which you’re comfortable.
Various lenders might specialize in certain types of unsecured lending, such as credit card companies, student loan lenders, peer-to-peer loan companies and payday lenders. Personal loans can come from a variety of sources, such as banks, credit unions and online lenders.
What happens if you don’t repay this debt?
There’s no collateral for the lender to claim if you default on an unsecured debt. The main leverage that lenders have to motivate borrowers to pay is a threat to the soundness of their credit rating. A high credit score is valuable — it’s what allowed the borrower to get the loan in the first place. So the desire to maintain it is a strong incentive for borrowers of unsecured loans to manage their debt properly.
If you fail to pay your unsecured debt, there are a variety of avenues that lenders can pursue as recourse. These actions can damage your credit to the point that it may be difficult if not impossible to repair.
- Send you to collections. The first step lenders usually take to try to get the money you owe them is sending your account to the lender’s collections department. This results in you receiving many calls and demanding letters requesting that you repay the loan in full right away. If you don’t do so, you could be passed along to a third-party collections agency, which will be more aggressive about working to get the money you owe.
- Inform the credit bureaus. Any late payments on your loan will show up on your credit report, usually once your payment is 30 days late. Your credit score will go down, but not nearly so much as it will if you enter collections. Going into collections depresses your credit score tremendously, a change that could take years to rectify and prevent you from getting new credit for a long time.
- Garnish your wages. If it can’t get money out of you any other way, the lender may take you to court and get an agreement to have your wages garnished to pay back the loan, as well as penalties, interest and collection costs. Wages can be garnished up to 25% of gross pay.
Another troublesome outcome of failing to pay an unsecured loan is that you can end up owing extra taxes. When you default on a loan outside of bankruptcy proceedings, your lender can write off some amount of the loan, which then becomes part of your taxable income.
Unsecured loans are extremely versatile lending instruments since the debt doesn’t have to be tied to anything more concrete than the borrower’s good record of repayment. This type of loan allows borrowers to pursue more intangible goals than purchasing homes and cars — life-enhancing things such as travel, celebration, education, debt consolidation and security.
The wide variety of unsecured loans and sources means that most borrowers will be able to find some option that works for them. Their eligibility, goals and needs vary, but lenders are motivated to find and engage with eager borrowers who are ready to take on a loan.