What Is Unsecured Debt?
Unsecured debt is a type of loan that is not backed by collateral, such as a house or a car. While this can mean higher interest rates, unsecured loans can grant better asset protection.
Unsecured debt is a loan not tied to an asset, like a home, automobile or investment. This means that if a borrower defaults on the payment or fails to repay the loan, the lender cannot seize their assets as compensation. However, this also leads to more risk for the lender, which is why unsecured debts often come with higher interest rates and trickier terms. Despite these downsides, unsecured debt also gives you access to debt relief options, such as debt management, debt consolidation and debt settlement.
While unsecured debt can be useful, it’s essential to understand its risks. Learn more about what unsecured debts are, how they compare to secured debts and how to manage them properly.
Unsecured debt is not backed by collateral, meaning lenders cannot repossess your assets if you default on payments.
Unsecured debt carries a higher interest rate than secured debt, as the former comes with a higher risk for lenders.
While unsecured debt can protect your assets better than secured debt, it can still put your credit score and overall financial standing at risk since lenders can report late payments and file lawsuits against you.
What Is Unsecured Debt?
Unsecured debt is a type of loan not backed by an asset or collateral. Because these loans aren’t backed by collateral, the lender is not entitled to claim your assets if you cannot repay your loan.
While unsecured debts protect your assets in this way, they don’t waive your responsibility to repay your loan. Lenders can penalize you in other ways if you default on payments. For instance, lenders can hire debt collectors, file a lawsuit against you or report your missed payments to credit bureaus — all of which can negatively impact your finances.
If you can’t repay your debts, you have the option to default on payments and avoid a lawsuit by filing for bankruptcy. However, this can severely impact your credit score and prevent you from securing loans in the future.
Difference Between Secured and Unsecured Debts
Unlike unsecured debts, a secured debt is a loan backed by collateral. Your collateral can be your home, car or something related to your business, such as your inventory. If you default on a secured loan, lenders have the right to seize the asset you put up as collateral. While this can be intimidating, secured debts often come with lower interest rates and flexible terms in exchange.
Secured Debts vs. Unsecured Debts
- FactorSecured DebtUnsecured Debt
Based on the collateral’s
Based on creditworthiness
More for documentation
Examples of Unsecured Debts
There are many types of unsecured debt meant for different purposes. For instance, credit card debt, student loans and medical loans are just a few of the many types of unsecured debts that an eligible borrower can access.
Review the different types of unsecured debts below to determine which one may be right for your circumstances.
- Credit Card Debt: Credit card debt is a type of revolving loan that gives you access to a credit limit that can be spent and repaid in a cycle. You can use it to fund everyday purchases or unexpected expenses.
- Personal Loans: Personal loans can be used for almost any purpose unless specified by the lender. While they are sometimes marketed under different names — such as wedding loans or home improvement loans — they all operate in essentially the same way.
- Student Loans: Student loans are funds dispersed for educational costs. These can be used for tuition fees, books or other expenses related to schooling.
- Medical Loans: A medical loan is a type of loan meant to pay for medical care, which can allow you to get the care you need without having to wait until you can afford it.
- Business Loans: Business loans are meant for business expenses. They can be used to pay for any business operating expense, such as inventory or wages, as needed.
Pros and Cons of Unsecured Debts
Unsecured debt can be a valuable financial tool if managed correctly, but it’s best to understand its advantages and disadvantages before making any decisions. After all, like all types of debts, unsecured debt comes with its fair share of risks.
For instance, even if lenders cannot seize your assets, defaulting on payments can still impact your credit score. Lenders can report your missed payments to credit bureaus, affecting your access to loans in the long run.
- Allows small payments over a long time
- Can improve your credit rating if paid regularly
- No asset or property risk
- Failure to pay will damage your credit rating
- Difficult to borrow from a lender
- Not tax-deductible
- Higher interest rate vs. secured debt
- Comparatively lower loan amount granted
At the end of the day, borrowers are in charge of how much an unsecured debt can benefit them. For instance, choosing only to borrow what you can repay can go a long way in helping you address your needs and financial situation. If you make your loan payments on time, you will ultimately impact your credit score positively. This can lead to lenders giving you more favorable terms in the future, such as a lower interest rate.
How to Manage Unsecured Debts
Knowing how to manage your debt is essential to financial success. Review MoneyGeek’s tips below to explore some helpful ways to pay off unsecured debts.
Pay on time by automating payments.
Late payments often incur late fees, which can bump up your minimum payment the next time your bill is due and make it even more difficult to make ends meet. Not to mention, paying late can negatively impact your credit score.
Automating your payments can ensure you pay them on time; money not seen is money not missed. If you can’t automate your payments, set a reminder on your computer or mobile phone for your bill’s due date.
Pay at least the minimum or more.
Your loan will often come with a minimum payment you must pay each month. While it’s easier to simply pay the minimum, putting more towards your debt can help you pay it down faster and reduce the amount of money you accumulate in interest. For instance, when you receive your tax refund, consider putting a significant portion of it toward your debt.
Prioritize debt by interest or balance.
After paying your necessary expenses, paying down your debt should be next on your list of financial priorities. Aim to tackle your debt strategically — this can mean prioritizing those with the highest interest or balance first, such as in the debt avalanche method. The sooner you can repay your debt, the more you can save on interest.
Negotiate with your lender.
If it’s becoming difficult to repay your loan, it’s possible to negotiate the terms with your lender. Approaching the lender with the desire to still repay the loan, rather than default, may open more flexible terms.
Avoid taking on more debt.
A good rule of thumb is to avoid opening more lines of credit if you already have one. For instance, if you maxed out your credit limit on one credit card, refrain from applying for another one.
How to Prioritize Unsecured Debts
It is not uncommon to have both secured and unsecured debts simultaneously, such as a mortgage and credit card debt. However, when it comes to prioritizing repayment, unsecured debts should always come first.
Even though you may have more to lose with a secured loan, unsecured debt has higher interest rates; addressing those right away can create more room to pay for low-interest debt faster and improve your credit score significantly.
Bankruptcy is also a way to address unsecured debt if you are unable to repay it. However, remember that this can negatively impact your credit score and keep you from accessing new loans and lines of credit in the future; with that in mind, it’s best to use this option as a last resort.
Review the steps below to understand how to prioritize your unsecured debts first.
- Step 1: Make a list of all your debts with their balances, interest rates and minimum payments. For example, say you had a mortgage with a 3.5% APR and a credit card with a 12% APR. Write these down, along with their balances and minimum payments.
- Step 2: Prioritize paying off the debt with the highest interest rate. In this case, you would prioritize your credit card debt as it likely has a higher APR than your mortgage. This means making minimum payments on your mortgage, credit card and any additional debts first, then focusing your extra repayments toward your credit card.
- Step 3: Go down the line of your debts. If you have more than a mortgage and credit card to pay for, tackle the next debt after the highest interest. However, be sure to continue paying at least minimum payments on all your debts. As you pay off each debt, it should become easier as the interest rates and payments become lower.
Consequences of Non-Payment
Although unsecured loans aren’t backed by collateral that lenders can seize, it doesn’t mean there aren’t other consequences. Lenders can charge you a hefty late fee if you fail to make payments on time, which can increase your minimum payment when your bill is next due. If you set up automatic payments and don’t have enough funds in your account, you may also be charged an overdraft fee by your bank.
These fees can make it even more challenging to repay your debt and may lead to a snowball of fees and interest that can result in bankruptcy; that’s why it’s important to ensure you pay at least the minimum payments on time.
Frequently Asked Questions About Unsecured Debt
Understanding what unsecured debt is can help you determine if it’s the right type of loan you want to take. Review some of the most frequently asked questions about debt below.
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