Any debt that is not secured by an asset, such as a house or a car, is referred to as unsecured debt. With unsecured debt, the lender may need to file a lawsuit to get the money they are owed if the borrower doesn’t pay.
Creditors frequently charge higher interest rates on unsecured debt due to the possibility that they won’t be paid.
On the other hand, secured debt is supported by collateral, which can be any asset or piece of property like a house. The lender may take possession of the collateral to cover the debt if the borrower is unable to repay the loan or other obligations.
A mortgage home loan, which is secured by the actual home, is the most typical type of secured debt.
Understanding Unsecured Debt
If any underlying assets do not support a loan, it is unsecured. Credit card debt, utility bills, medical expenses, and other debts granted without collateral are examples of unsecured debt.
Unsecured loans pose a unique risk to lenders because the borrower may decide to declare bankruptcy to default on the debt. In this case, the lender may attempt to sue the borrower to recover the loan balance. However, the lender might not be able to recoup their initial investment if no specified assets were pledged as collateral.
Although declaring bankruptcy may let borrowers postpone paying off their obligations, it also has drawbacks.
The bankruptcy will severely negatively influence the borrower’s credit score, probably for many years to come, making it difficult or impossible for them to obtain new loans in the future.
Meanwhile, lenders can look for other ways to recoup their investments. Lenders may also report any instances of default or delinquency to a credit rating agency in addition to suing the borrower.
Alternatively, the lender may employ a credit recovery company, which will try to recover the unpaid amount.
What Sorts of Debt Are Unsecured?
Unsecured debt involves a variety of debts, including:
- Credit card debt
- Debt brought on by medical expenses
- Unpaid utility bills
- Education loans
- Debt associated with specific sorts of court rulings
Lastly, unsecured loans include personal loans that do not require the borrower to pledge assets as collateral.
Example of Unsecured Debt in the Real World
Private lender Max focuses on unsecured loans. A new borrower named Elysse approaches him and asks for a loan of $20,000 from him.
Elysse is not obligated to offer any specific assets as security if she defaults on the loan because it is unsecured. Max charges her an interest rate that is greater than rates applied to loans with collateral as compensation for this risk.
Six months later, the debt defaults due to Elysse’s repeated late and missed payments. Max has a few options to think about.
Although Max may try to sue Elysse for the loan’s payback, he believes this would be pointless because no specific assets have been pledged as collateral. Instead, he decides to employ a collection agency to seek loan payback on his behalf.
Max consents to pay the collection agency a portion of any sum that the collection agency successfully retrieves as payment for this service.
Agencies that handle collections charge on a contingency basis. Collection types, sizes, and ages all affect how much is collected. Each account ranges in price from 7.5% to 50%, with consumer rates often hovering around 35%.
Max may have used the secondary market to sell the loan to a different investor. He probably would have sold the debt for much less than its face value in such a case. The new investor would accept the risk of not being reimbursed in return for the discounted buying price.
Secured Debt vs. Unsecured
In contrast to unsecured debt, secured debt is backed by an asset. Auto loans and mortgages are two of the most prevalent types of secured debt. A lender can reclaim your car or foreclose on your house if you don’t pay those bills.
Lenders usually impose lower interest rates since assets back secured loans. For instance, secured home equity loans have an average rate of 5.78 percent. In comparison, unsecured personal loans have an average rate of 11.88 percent, even though they are equivalent products in terms of loan amounts and payback durations.
But both unsecured and secured loans have an effect on your credit. TransUnion, Experian, and Equifax, the three major credit agencies, may be notified if you don’t make a payment on time.
Are There Any Repercussions for Failure to Repay Unsecured Debt?
If the borrower defaults on the loan by failing to make payments, the creditor may frequently file a lawsuit against them. Usually, wage garnishment follows this. Garnishment of earnings occurs when the creditor is permitted to directly remove money from the borrower’s paycheck to pay off the loan.
The creditor still has access to the debtor’s assets and possessions when the debt is unsecured. They will typically need to file a lawsuit first, though. This is not a secured debt, where the creditor can seize the property without filing a lawsuit. They are able to do this because, as a condition of the loan arrangement, the borrower typically agrees to turn over the collateral property in the event of a default.
The borrower may resolve their debt by negotiating with the lender or filing for bankruptcy and receiving a discharge before bringing a lawsuit. The creditor can also take less drastic actions, including damaging the borrower’s credit score and reporting the non-payment to a credit agency.
Since payment history makes up 35% of your credit score, your score will drop after your debt is turned over to a collection agency. This will make it more difficult for you to get loans in the future.
If you don’t pay back your debt, depending on the type of unsecured loan you have, your income could be withheld. Additionally, a creditor may file a lawsuit against you and put a lien on your assets. Your assets may be at risk if the court gives the lender a judgment. What personal property would be excluded from seizure depends on state law.
What to Do About Unsecured Debt
Paying off the debt or declaring bankruptcy are the two main alternatives for handling unsecured debt.
There are various options on how to repay the debt. You can adjust your spending to pay off the debt more quickly if you can cut costs elsewhere by allocating more of your disposable or unassigned income to paying it off. But if it isn’t financially feasible, you might have to restructure your unsecured debt.
This can be accomplished by contacting your lender and negotiating new loan conditions that reduce your monthly payments or interest rate.
You can also apply for a debt consolidation loan to replace old debt with new debt, often at a reduced interest rate. However, because they will terminate several accounts while accruing new debt, these loans are not always advantageous to you and could harm your credit.
Do I Require Legal Counsel for Unsecured Debt Issues?
A borrower may find it simpler to get an unsecured loan than secured debt. Unsecured debt is nevertheless linked to a number of legal problems and specific legal conflicts. If you require assistance with unsecured debt problems, you could employ a credit attorney.
To find out what rights you have under credit and finance laws in your state, your attorney can assist in conducting legal research. Your attorney can also defend you in court if you need to file a lawsuit or show up for a hearing because of a legal issue.