1. DEBT SOLUTIONS

What is Unsecured Debt?

What is Unsecured Debt?
Richard BarringtonNovember 5, 2020
Key Takeaways:
  • Unsecured debt is a loan without collateral.
  • Unsecured debt is riskier than secured debt for lenders.
  • Most debt relief strategies apply to unsecured debt.

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All debt is either secured or unsecured.

Secured debt refers to loans that are backed by collateral. Collateral is property that the lender can take if you fail to repay the loan.

For example, if you don't make your car payment, your lender can repossess the car and sell it. If you default on your mortgage, the lender can foreclose, evict you, and sell the property to get its money.

This article explains some of the key differences between secured and unsecured debt, as well as the advantages and disadvantages of each. Topics covered include:

  • Secured vs Unsecured Debt

  • Examples of Unsecured Debt

  • Advantages of Secured vs Unsecured Debt

  • Prioritizing Secured vs Unsecured Debt

  • Dealing with Unsecured Debt Problems

  • Taking Control of Your Unsecured Debt

  • Unsecured Debt FAQs

Secured vs Unsecured Debt

Secured and unsecured debt are different products with varied requirements. Here is how they stack up.

What is secured debt? 

Secured debt requires the borrower to put up collateral. Collateral is an asset that the borrower pledges to the lender. If the borrower doesn’t make the required loan payments on a secured loan, the lender can take the pledged asset. That makes the loan less risky for the lender. Because there is less risk with a secured loan, it’s easier to get approved and the interest rate should be lower.

You probably already have at least one secured loan. According to the Federal Reserve’s Survey of Consumer Finances, the most common type of debt is mortgage debt, which is secured. Nearly half (46.8%) of US households have debt that’s secured by their primary residence or other residential property.

When you buy a car with auto financing, the car you purchase is the collateral for the loan. If you have a mortgage, the property you’re buying is collateral for the loan. But sometimes, you might pledge an asset not tied to the loan – with an auto title loan, for example, you pledge your car but use the loan proceeds for other things. 

What is unsecured debt?

Unsecured debt is a loan or other form of credit without collateral. The lender must rely on the borrower’s ability and willingness to pay what’s owed. This makes unsecured debt riskier for lenders. Unsecured loans are harder to get and their interest rates are higher. 

To verify your willingness and ability to repay your debts, lenders examine your credit history, credit score, employment history, and your debt-to-income (DTI) ratio. Your DTI ratio equals the total of your housing cost (rent or mortgage) plus other debt payments, divided by your gross (before tax) monthly income. 

For example, if your gross monthly income is $5,000, and your mortgage, car loan, and credit card minimums total $3,000, your DTI equals $3,000 / $5,000 or 60%. That’s a very high DTI and it will probably keep you from borrowing. 

A credit score of 670 or greater would normally put you in position to qualify for an unsecured loan, as long as your DTI ratio isn’t too high. While there are unsecured loans that accept a DTI as high as 50%, most lenders want to see a lower number – 43% or even 38%. 

Lenders avoid people with poor credit scores or a high DTI ratio. These things matter when you apply for a secured loan, but they are especially important when it comes to unsecured loans.

Examples of Unsecured Debt

While mortgage debt is the most common type of loan in the US, unsecured credit card debt is close behind it. Over 45% of US households have credit card debt, though these debt balances tend to be a lot smaller than mortgage balances. Student loans are unsecured because you cannot repossess a person’s education if student loans go unpaid.

Personal loans are kind of a hybrid category. These are usually unsecured, but putting up collateral can make a personal loan easier to get and improve the loan terms.

To summarize, the following table shows secured vs unsecured debt status for some common types of borrowing:

Secured debt:

  • Mortgages

  • Home equity loans

  • HELOCs

  • Auto financing

  • Boat loans

  • Secured credit cards

  • Secured personal loans

Unsecured debt:

  • Most credit cards

  • Unsecured personal loans (signature loans)

  • Student loans

  • Personal lines of credit

Advantages of Secured vs Unsecured Debt

On the surface, unsecured debt might seem like a great deal for a borrower. You get to borrow money without putting up any collateral, so the lender takes all the risk. (Lenders can take you to court, however, if you don’t pay your unsecured debt.) Unsecured loans (except student loans in most cases) can be discharged in bankruptcy. What’s not to like?

The catch is that because the lender’s risk is greater, unsecured debt carries a higher interest rate than secured debt. If you’re highly qualified, the difference may be very small. But if you have a poor credit score or a limited credit history, an unsecured loan’s interest rate could be high – as high as 36% for mainstream personal loans. You may have trouble getting unsecured credit at all if your DTI is high and your credit score is low. 

One advantage of unsecured debt is that the loan process is faster. The lender doesn’t have to evaluate any collateral, and these days you can often verify someone’s bank balances, salary, and credit history in minutes.

The advantages of secured debt are that your costs are likely to be lower – in some cases, much lower. It’s easier to get loan approval for secured debt. In fact, secured debt can be a good way of establishing or rebuilding your credit history. 

A secured credit card, collateralized personal loan, car loan, or mortgage can let you show your ability to make payments on time. Doing that consistently will give lenders more confidence about extending unsecured credit in the future. 

Prioritizing Secured vs Unsecured Debt

When you have multiple debts, it’s important to arrange them by which should be repaid first. This can lower the cost of your total debt. It can also guide you if there comes a time when you can’t make all of your debt payments. 

The tricky thing when you have a mix of secured and unsecured debt is that they both have reasons why you should repay them first. Unsecured debt is likely to be more expensive, but failing to pay secured debt could mean losing the collateral you put up. 

Weighing these things, you should organize secured and unsecured debt repayment in this order:

  1. Make the minimum payment on each debt.

  2. If you can’t make all your minimum payments, pay collateralized debt first so you don’t risk losing your collateral.

  3. If you can make all your minimum payments and have some money left over, put the extra toward paying down the most expensive debt first. That debt is likely to be unsecured.

  4. Once you pay off one debt, put any extra towards paying off the debt with the next highest interest rate first.

Dealing With Unsecured Debt Problems

Prioritizing your debt payments can make repayment as cost-effective as possible. If you can’t repay your debts, you can consider the options outlined below. 

Refinancing

Refinancing means replacing one debt with another. You do this to improve the terms of your debt.

For example, you may pay off one account with a new loan that has a lower interest rate. Or you could choose a new loan with a lower payment. More time to pay can give you some breathing room if money is tight, although it’s likely to cost more in the long run.

Debt Consolidation

Debt consolidation is like refinancing, except you use a new loan to pay off multiple old loans.

Like refinancing, this can change repayment terms to suit your needs. It has the added advantage of combining a variety of different monthly payments, due dates, and loan balances into one. That can make your debt a lot easier to manage.

It’s important to understand that debt consolidation does not wipe out your debts. You still owe the same amount. Avoid running balances back up once your credit cards have been paid off. 

Debt Management Plan (DMP)

Credit counseling agencies often offer clients with unsecured debt problems a debt management plan (DMP) to help them organize their debts. As part of the plan, a counselor might be able to negotiate better interest rates, lower payments, or fee waivers. They can sometimes get your accounts “re-aged” which brings them current and improves your credit scores. 

A DMP is a specialized program for debt consolidation that requires that you make a payment into it each month. Your counselor then distributes the money to your various creditors. Your payment will probably include a payment for the DMP service. You often must close most or all of your credit cards when you enroll in a DMP. That’s to keep you from running up balances when you are trying to become debt-free.

Even if a debt management company is handling your payments for you, it’s important to keep track of where the money goes. You need to make sure the plan is making payments correctly and the amount you owe is going down.

DMP fees can mean it costs more to repay your debts unless the debt management company can save you more than the fee by negotiating lower interest rates. Any extra cost is only worth it if you can’t organize your loan payments yourself.

Debt Relief Programs

While a DMP is focused on finding a way to pay what you owe, debt relief programs (also known as debt settlement) involve getting creditors to accept less than what you owe as payment in full. 

Getting creditors to settle for less than full repayment of your debts does long-term damage to your credit record. That will make it more difficult and more costly to get credit in the near future.

Besides the damage to your credit record, there is a direct cost to debt settlement. You’ll have to pay the debt relief company a fee, though by law they cannot collect this fee until the debt is settled.

Because a creditor is unlikely to accept less than the full amount owed if there is collateral for them to fall back on, debt relief programs generally apply to unsecured rather than secured debt. 

Taking Control of Your Unsecured Debt

While unsecured debt does not have any collateral at stake, there are still steep penalties for defaulting on (not paying) what you owe. For one thing, you can be sued in court. And if you lose you’ll have to pay what you owe and likely court costs and penalties as well.

So, take action if you are having trouble keeping up with your debt payments. The answer may be as simple as prioritizing your debts. Or, refinancing and debt consolidation may ease your immediate problems and supply long-term benefits.

If you can’t find a good option for meeting your debt obligations, consider more drastic measures like a DMP or debt relief. The problem won’t go away if you simply ignore it; it will get worse. 

Unsecured Debt FAQs

How do I qualify for unsecured debt?

Creditors look at a variety of things. Your credit history is one factor, but so is your current financial situation. This includes your income, the stability of your job history, and how much debt you already have compared to your income.

If I have no collateral at stake with credit card debt, why would I pay more than the minimum required payment?

Simply put, the faster you repay your debt, the less interest it costs in the long run. In fact, credit card companies want you to only pay the minimum required amount so that you pay interest for a longer time. You can beat the credit card companies at this game by paying more than the minimum required payment. 

Is it a good idea to change secured debt into unsecured debt so I don’t have collateral at risk?

That may benefit you if you end up defaulting on your debts, but it’s an expensive strategy. For one thing, unsecured debt comes with higher interest rates than secured debt, so this approach would cost you. Plus, as noted in this article, even without collateral at stake there are consequences to defaulting on unsecured debt. 

Achieve financial control. How much debt do you have?

$25,000
Get your FREE plan now

Or speak to a debt consultant  800-910-0065

Frequently Asked Questions

What happens if you can't pay unsecured debt?

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Unsecured debts must still be paid. Just because the lender can't take property from you for non-payment doesn't mean you just walk away. Lenders can sue you for payment and possibly garnish your paycheck or attach your bank account. They can send your account to a collections agency. They may be able to contact you often and harass you about your debt. And they can report your default and harm your credit score.

Can adding a co-signer help you get approved for an unsecured loan?

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Lenders pay strict attention to your credit score and history when you apply for an unsecured loan. That's because with no collateral, all they have to rely on is your promise to repay your loan. Your past payment history tells them how likely you are to keep that promise.

If you have a poor payment history and no collateral to pledge as security, adding a co-signer can convince a lender to take a chance on you. Of course, your co-signer is taking a big chance on you because co-signers get stuck for the loan if the primary borrower doesn't pay. And if you make late payments and the lender reports to credit bureaus, it can hurt your co-signer's credit score. So only add a co-signer if you are certain that you'll make your payments on time.

Why are interest rates higher for unsecured loans?

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Secured loans are safer for lenders because if the borrower defaults, the lender can simply take the collateral and sell it to recoup the loan balance.

The opposite of this is the unsecured loan. There is no property and the lender might have to sue to get repaid. In addition, the default rate is higher for unsecured debt. That means there is a greater chance that the borrower will not pay the loan back. Lenders must charge more to make up for the added risk.