Unsecured Debt

Unsecured loans offer borrowers a reserve to buy things quickly, or pay off debts that become due, but they often come with high interest rates, and the terms can be tricky.

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Unsecured debt is any debt that is not tied to an asset, like a home or automobile. This most commonly means credit card debt, but can also refer to items like personal loans and medical debt. Unsecured debt creates less stress and fewer problems for consumers because they don’t stand to lose an asset if they don’t repay the debt.

If you fall behind on payments for unsecured debts, your lenders have no claim on your property and cannot repossess items or foreclose on your home. That’s the big difference between unsecured and secured debt.

Unsecured debt also what allows you to explore debt-relief options such as debt management, debt consolidation and debt settlement to help you clear your debt faster and for less money.

Credit Card Debt

Credit card debt is the most pervasive type of unsecured debt, and it’s on the rise again. Americans topped $1 trillion on their cards at the start of 2017, the highest it’s been since the Great Recession in 2008. It is a revolving line of credit, meaning you can continue to borrow each month and carry balances over. As with other loans and debts, it’s best to pay more than the minimum payment each month. This is an especially important principle with credit cards because interest rates, which already average 15.3%, can increase to 25-29% or higher if you fail to make payments. Paying more than the minimum will get you out of debt faster and save you hundreds — sometimes, even thousands — of dollars in interest.

Not all credit cards are unsecured. There are secured credit cards, which are backed by an initial deposit. The deposit is equal to the spending limit on the card. Late payments are still reported to credit bureaus, and the bank will keep the deposit if you default.

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Personal Loans

Personal loans (or “signature loans”) can be used for a wide variety of purposes, from funding a start-up business to paying for repairs on your home to taking a vacation. A personal loan typically has a cap and is funded by a bank, credit union or online lending source. Original lending terms depend on your credit history. A good credit score means a lower interest rate and money saved. Most personal loans have lower interest rates than credit cards, making them a more appealing option for planned expenses.

Lenders will typically want to confirm your identity and ability to repay the loan. They will want identification like a driver’s license, Social Security card or passport. They’ll also want to verify your address and income, which might require you to present employment pay stubs, bank statements and tax returns.

Learn more about personal loans

Business Loans

Many businesses use unsecured lines of credit for cash on demand. If an expected expense crops up — especially one that could cripple or ruin a business — a bank credit line can be a lifesaver.

Credit lines are basically pools of cash that business owners can tap when money is short and needs are intense. It is important to understand how a credit line works before it’s needed. Borrowers should understand how quickly they can access the cash, how competitive the interest rates are and whether the line comes with flexible repayment options.

Bank credit lines come in two varieties. Traditional lines offer a fixed amount of available money and often come with check-writing privileges. They can be difficult to obtain and maintain. Following the 2008 recession, many lenders slashed credit lines at a time when businesses needed credit the most. In some cases, banks called in the credit lines early, forcing the borrowers to arrange repayment on short notice.

A better alternative is a non-traditional credit line, typically obtained as a company credit card. Like a traditional credit line, unsecured credit cards allow borrowing up to a limit with far less chance the credit offer will be withdrawn.

Business credit cards often offer:

  • Quick access to cash
  • High credit limits, many with low initial APRs
  • Flexible repayment options
  • Separation of business credit from personal lines, which protects business owners from individual liability in the case of default

Also, keep in mind that businesses have their own credit ratings similar to the credit scores that measure individual consumers. Businesses ratings are usually on a scale of 1-100 and measure credit worthiness of companies and the likelihood they will repay loans.

These credit ratings help determine whether a business will be approved for a loan and the interest rate they will be charged. That is especially important to startup businesses, which rely on loans to help them get on track. A poor credit rating could be disastrous.

Peer to Peer Loans

These are loans that individuals make to one another. Like signature loans, these are usually fixed-rate installment loans. Often, the lender is a family member or close friend, but some websites allow would-be borrowers to post requests. Sites to investigate for this type of loan include Prosper.com and Lending Club.

Private Student Loans

Private student loans are another source of overwhelming debt. Americans carried $108.2 billion in private student loans — or about 7.7% of the $1.4 trillion owed for this type of debt in 2017. According to the Project on Student Debt from the Institute for College Access & Success, members of the 2016 college graduating class left campus with an average of $37,172 in academic debt. Private student loans are similar to personal loans: they are funded by banks or other private lenders, and their terms depend on your credit history. However, as with federally funded loans, private student loans come with perks to allow students the time and resources they need to concentrate on their studies. In general, private student loan payments are deferred until after graduation.

Learn more about private student loans

Medical Debt

Medical bills are a unique form of unsecured debt. While you can choose to make purchases on a credit card and you can choose to fund an education with student loans, no one chooses to fall ill and incur medical bills. Still, 40% of Americans had debt related to illness and a report from the Kauffman Family Foundation said that 25% of Americans say someone in their household is struggling to pay medical debt. An estimated 1.7 million people live in households experiencing bankruptcy because of medical costs and another 64 million Americans struggled to pay medical bills in 2014.

Learn more about medical debt

Apartment Leases

While rent isn’t typically considered debt, when you fall behind on paying it, you actually become indebted to your landlord. If this happens, your landlord is likely to take action in order to evict you unless you find help paying rent. However, since you are not at risk of losing any belongings, your debt is considered unsecured.

Cellphone and Utility Bills

As with unpaid rent, unpaid cellphone and utility bills are unsecured debts. If you are late paying your bills, servicing companies may disconnect your phone or utilities. However, they are not entitled to any of your assets or belongings.

Auto Repossession Overage Balances

If you miss enough payments on your auto loan, your lender likely will repossess your car. The lender then sells the car to recoup what you owed. If your car has lost value faster than you’ve repaid the loan, it’s possible the funds from the sale will not cover the entire amount you owe. The difference, called the auto repossession overage balance, is your responsibility. Since your lender has already confiscated the only asset to which it is entitled, this debt is unsecured.

Short Selling Real Estate

A short sale is one way to market your home if it’s underwater (or worth less than you owe on your mortgage). A mortgage holder may agree to accept the proceeds of a short sale as long as you agree to pay the balance of the debt over time through an unsecured loan. This is called a short sale payoff.

For example, assume you owe $120,000 on property worth $100,000.  Your lender may be willing to settle the debt for only $110,000, leaving an unpaid balance of $10,000. You will continue to make payments on the $10,000 balance even after your home is sold.

Lenders are also willing, in some cases, to forgive the unpaid balance. If this is offered — often in markets where real estate values have dropped considerably — remember there may be tax consequences. The IRS can count debt forgiveness as income to the borrower.

A short sale might be a good strategy for a borrower who is current on a mortgage and has a strong credit rating, but there is no guarantee a lender will go along. The lender, after all, is interested in getting the best deal possible, and if that means foreclosing, a short-sale proposal might be rebuffed.

Advantages and Disadvantages of Unsecured Loans

Though unsecured loans aren’t tied to assets like houses and cars that can be seized if the loan isn’t repaid, they are hardly without risk. Failure to pay can severely damage an individual’s or business’ credit rating — commonly measured as a FICO score — making it difficult to obtain credit again for a substantial amount of time.

Unsecured loans offer borrowers a reserve to buy things quickly, or pay off debts that become due, but they often come with high interest rates, and the terms can be tricky. Credit card debt, for instance, allows borrowers to make small minimum payments over long periods of time, but interest rates are usually much higher than those attached to secured loans. Lenders charge the higher rates to compensate for risk – if you default, they can’t take an asset to cover their losses.

For people who pay off debt on schedule, unsecured loans have tremendous advantages. They allow borrowers to improve their credit rating quickly, which can mean bigger credit lines and lower interest rates on revolving debt. If lenders see a good repayment history, they are far more likely to offer more credit at favorable terms.

Unlike home loans, interest paid on unsecured loans isn’t tax deductible. For that reason, many homeowners opt for home equity lines of credit that allow them to borrow against the equity in their homes, often using a cash card. Of course, that isn’t without risk: if a borrower fails to make required payments, the lender can foreclose on the borrower’s home.

Unsecured loans can curtail extra expenses. If you take out a home or car loan, the lender will require that you carry insurance on the asset.

Pros and cons for unsecured loans:

  • Pro: No asset risk
  • Pro: Shorter repayment term (lower cost in interest over time)
  • Con: Harder to obtain from a lender (high risk borrower)
  • Con: Lower borrowing amount allotted
  • Con: Higher interest rate
  • Con: No tax benefit

Unsecured Loan Borrowing Methods

Your mother might not require you to sign papers for a loan, but most institutional lenders will.

Whether you apply for a credit card, a signature loan or a non-collateralized line of credit, you’ll have to sign documents, often with copious fine print. Before you agree to sign, review the terms. For instance, if you see a credit card with a low initial rate, called a teaser, it probably will switch to a much higher interest rate after a fixed period.

Whenever possible, stay current with payments. If you can pay off credit card balances in full each month, do so. In fact, credit cards often come with perks like frequent-flyer miles and cash back rewards, which are free money to those who aren’t saddled with interest payments.

When you apply for an unsecured loan, expect to answer questions about your net worth and income. Also expect the lender to research your credit history. If you have payment problems, loans can be denied, or might come with very high interest rates.

Recently, many credit card companies and financial web sites have made it easy for customers to check their FICO credit-worthiness scores. FICO scores can also be purchased from the nation’s 3 large credit rating agencies. It’s always a good idea to know your FICO score in advance, as a high one will allow you to insist on favorable terms and a low one might require extra documentation.

You might also consider steps for improving your credit score, which almost always involves paying down debt in timely installments.

Failure to Repay a Loan

Unlike a secured loan, where the collateral is stipulated, unsecured loans are problematic.

If a borrower fails to repay, the consequences can range from frequent calls from collection agencies to lawsuits. The lender of a delinquent or defaulted loan will report the borrower to the nation’s 3 credit report reporting agencies, which in turn will severely lower the borrower’s credit-worthiness quotient, known as the FICO score. A low FICO score makes it more difficult to obtain credit. This also makes borrowing any possible credit costlier.

Employers also use credit scores in hiring decisions, concerned that a poor credit history reflects a lack of character. Failure to repay a debt can remain on a credit report for as long as seven years.

Court Judgements and Tax Debt

Unsecured debt isn’t backed by any property, but a lender can try to reclaim their money in the court system. They can pursue a court judgement through a debt collection lawsuit. The borrower is summoned to court, where failure to show up grants the decision in favor of the lender. State statutes commonly stipulate how long a creditor has to file a collection suit after repayment terms are violated.

If the lender is successful in court, they receive a judgement, which legally entitles them to the money owed. They can collect their due using alternative methods including garnishing wages, seizing property and freezing bank accounts.

Borrowers still have options after a court judgement. They can appeal the decision, discharge the debt through bankruptcy or more commonly settle the debt.

Taxes are not considered unsecured debts. They’re in a class of their own, and the penalties for failing to pay taxes are severe. For starters, there are late fees and interest compounded daily. If the situation goes unresolved, the government can file a claim against property (Federal tax lien), seize property and assets (Federal tax levy), take part or all of a tax refund and garnish wages. The government can do all of this without a court judgement, and taxes cannot be discharged through bankruptcy. It’s best to tackle the issue early, and set up a repayment plan with the IRS.

Settling Unsecured Debt

Any unsecured debt may be eligible for settlement, a debt-reduction strategy aimed at reducing the total amount you owe. It is a useful strategy for individuals who find themselves with more debt than they can handle and want to get their finances back on track. It often is done with the help of a debt settlement specialist, who can speak to your creditors on your behalf and often negotiate reduced balances.

If you are saddled with more debt than you can handle, a debt consolidation plan might be the way out. Debt consolidation allows you to combine several unsecured debts into a single loan and single payment that satisfies all your creditors. It may also lower your interest rate and monthly payments. It is often done with the help of a credit-counseling agency which can speak to creditors on your behalf and often arrange for lower interest rates. To get an initial idea of what it will take, try using a Debt.org’s loan consolidation calculator.

Priority vs Non-Priority Debt

Bankruptcy could be the best option in cases of extreme financial hardship, and not all debts are treated equal in this process. The priority and non-priority titles indicate the order in which the trustee disburses money from the estate to creditors.

Priority debts are taxes, alimony, child support and criminal fines. These get paid first and can’t be discharged through bankruptcy, which means you’re still on the hook for them after bankruptcy.

Non-priority debts are credit-card balances, personal loans, utilities, medical bills and student loans. These are paid with whatever money is left over after the priority debts are taken care of. If there’s no money left, most non-priority debts are discharged and go unpaid Student loans are rarely discharged in bankruptcy and need a separate lawsuit.

About The Author

Max Fay

Max Fay has been writing about personal finance for Debt.org for the past five years. His expertise is in student loans, credit cards and mortgages. Max inherited a genetic predisposition to being tight with his money and free with financial advice. He was published in every major newspaper in Florida while working his way through Florida State University. He can be reached at [email protected].


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