What Is Unsecured Debt?
Unsecured debt refers to loans that are not backed by collateral. If the borrower defaults on the loan, the lender may not be able to recover their investment because the borrower is not required to pledge any specific assets as security for the loan.
Because unsecured loans are considered riskier for the lender, they generally carry higher interest rates than collateralized loans.
Key Takeaways
- Unsecured debts are loans that are not collateralized.
- They generally require higher interest rates, because they offer the lender limited protection against default.
- Lenders can mitigate this risk by reporting defaults to credit rating agencies, contracting with credit collection agencies, and selling their loans on the secondary market.
Understanding Unsecured Debt
A loan is unsecured if it is not backed by any underlying assets. Examples of unsecured debt include credit cards, medical bills, utility bills, and other instances in which credit was given without any collateral requirement.
Unsecured loans are particularly risky for lenders because the borrower might choose to default on the loan through bankruptcy. In this situation, the lender can seek to sue the borrower for repayment of the loan. However, if no specific assets were pledged as collateral, the lender may be unable to recover their initial investment.
Because unsecured loans are considered more risky for the lender, they generally carry higher interest rates than collateralized loans.
Although bankruptcy can allow borrowers to avoid repaying their debts, it is not without its consequences. Borrowers who have declared bankruptcy in the past may find it difficult or impossible to secure new loans in the future, since the bankruptcy will have a severe negative impact on their credit score, likely for many years to come.
Lenders, meanwhile, may seek alternative methods for recovering their investment. In addition to suing the borrower, lenders can also report any instances of default or delinquency to a credit rating agency. Alternatively, the lender can also hire a credit collection agency that will then seek to collect the unpaid debt.
Real-World Example of Unsecured Debt
Max is a private lender specializing in unsecured loans. He is approached by a new borrower, Elysse, who wishes to borrow $20,000.
Because the loan is unsecured, Elysse is not required to pledge any specific assets as collateral in case she defaults on the loan. As compensation for this risk, Max charges her an interest rate that is higher than rates associated with collateralized loans.
Six months later, the loan becomes delinquent due to a series of late and missed payments by Elysse. Max has several options to consider:
Although Max could seek to sue Elysse for repayment of the loan, he suspects this would not be worthwhile because there are no specific assets pledged as collateral. As an alternative, he chooses to hire a collection agency to pursue repayment of the loan on his behalf. As compensation for this service, Max agrees to pay the collection agency a percentage of any amount that the collection agency succeeds in recovering.Collection agencies charge on a contingency fee basis. Collection rates vary by collection type, size, and age. They average between 7.5% and 50% for each account, with consumer rates typically around 35%.
Another option: Max could have sold the debt to another investor using the secondary market. In that scenario, he would have likely sold the debt at a considerable discount to its face value. In exchange for the discounted purchase price, the new investor would assume the risk of not being repaid.
FAQs
Examples of unsecured debt include credit cards, medical bills, utility bills, and other instances in which credit was given without any collateral requirement. Unsecured loans are particularly risky for lenders because the borrower might choose to default on the loan through bankruptcy.
Do you have to pay off unsecured debt? ›
If you neglect to pay off unsecured debt, it's unlikely your possessions would be reclaimed by a lender. But if you stop making payments, you may be hounded by debt collectors calling, emailing and texting you to try and convince you to pay the debt down.
Is unsecured debt bad? ›
Unsecured loans are a great financing option for people who don't want to offer up collateral, which is something of value a lender can repossess to recoup its losses if you default. However, the lender takes on more risk without collateral and typically charges higher interest rates to compensate for the added risk.
What happens to unpaid unsecured debt? ›
Defaulting on an Unsecured Loan
As mentioned previously, however, a collection agency may try to sue you for the unpaid amounts you owe, attempt to garnish your wages, or place a lien on your home through a court order. 5 And, as with a secured loan, you can expect a serious impact on your credit score.
How do you resolve unsecured debt? ›
Debt relief through a debt management plan
A debt management plan allows you to pay your unsecured debts — typically credit cards — in full, but often at a reduced interest rate or with fees waived. You make a single payment each month to a credit counseling agency, which distributes it among your creditors.
What is the average amount of unsecured debt? ›
Average personal loan debt in 2023: $11,925
According to TransUnion, the average unsecured personal loan amount in October 2023 was $7,608, down from $7,934 in October 2022.
How long before unsecured debt is written off? ›
For most debts, the time limit is 6 years since you last wrote to them or made a payment. The time limit is longer for mortgage debts.
Do unsecured loans hurt credit? ›
A personal loan can affect your credit score in a number of ways—both good and bad. Taking out a personal loan isn't bad for your credit score in and of itself. However, it may affect your overall score for the short term and make it more difficult for you to obtain additional credit before that new loan is paid back.
Can you walk away from unsecured debt? ›
Because there are real consequences associated with failure to pay unsecured debt, simply ignoring it after defaulting is never an option. There are things you can do to address the loan default and either keep it from getting worse. You may even be able to legally free yourself of the obligation to repay it for good.
How much unsecured debt is too much? ›
Debt-to-income ratio is your monthly debt obligations compared to your gross monthly income (before taxes), expressed as a percentage. A good debt-to-income ratio is less than or equal to 36%. Any debt-to-income ratio above 43% is considered to be too much debt.
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.
What is too much unsecured debt? ›
Most lenders say a DTI of 36% is acceptable, but they want to lend you money, so they're willing to cut some slack. Many financial advisors say a DTI higher than 35% means you have too much debt.
What happens if you never pay collections? ›
If you don't pay, the collection agency can sue you to try to collect the debt. If successful, the court may grant them the authority to garnish your wages or bank account or place a lien on your property. You can defend yourself in a debt collection lawsuit or file bankruptcy to stop collection actions.
What happens after 7 years of not paying debt? ›
The 7-year rule means that each negative remark remains on your report for 7 years (possibly more depending on the remark). However, after that period has ended, a remark will most probably fall off of your report.
Is it true that after 7 years your credit is clear? ›
Most negative items should automatically fall off your credit reports seven years from the date of your first missed payment, at which point your credit score may start rising. But if you are otherwise using credit responsibly, your score may rebound to its starting point within three months to six years.
What is the most common example of unsecured credit? ›
Unsecured Loan. Unsecured loans are exactly what they sound like - unsecured. Credit cards, student loans, or personal loans are considered unsecured loans. Lenders take a larger risk by offering this type of loan to an individual since there is no asset to seize if a borrower defaults.
Which type of debt is often unsecured? ›
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.
What are examples of unsecured creditors? ›
Some of the most common types of unsecured creditors include credit card companies, utilities, landlords, hospitals and doctor's offices, and lenders that issue personal or student loans (though education loans carry a special exception that prevents them from being discharged).
What are examples of secured and unsecured debt? ›
Examples of secured debt include mortgages, auto loans and secured credit cards. Unsecured debt doesn't require collateral. But missed unsecured debt payments or defaults can still have consequences. Examples of unsecured debt include student loans, personal loans and traditional credit cards.
