What is Unsecured Debt?

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Unsecured debt represents a significant portion of many individuals' financial burdens, encompassing everything from credit card bills to medical debts and personal loans.

Unlike secured debt, which is backed by collateral, unsecured debt relies solely on the borrower's creditworthiness and promise to repay. This article delves into the nuances of unsecured debt, highlighting the key differences from secured debt, exploring the various types, and assessing the risks and benefits associated with this form of borrowing.

Whether you're navigating credit card payments or considering a personal loan, understanding the landscape of unsecured debt is crucial for effective financial management and planning.

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Types of Unsecured Debt

The most common forms of unsecured debt are credit cards, medical bills, personal loans, and some student loans. Each type of debt breaks down into term and revolving loans. A term loan includes personal loans, car loans, and mortgage loans. A revolving loan includes credit cards and home equity lines of credit. We will discuss revolving and term unsecured debt in more detail.

Credit Card Debt

Credit cards are unsecured revolving debt. This type of debt has a credit limit (the amount you can borrow). You only pay for the portion you use and you can use up to your credit limit. The ability to use up to your credit limit theoretically never changes.

In addition, you pay interest on the amount you borrow, the amount you have not paid off each month, and the interest rates accrued each month.

Credit card debt tends to come with higher interest rates.

Most Americans have roughly $5,000 to $6,000 in credit card debt.

Medical Debt

Medical debt is another leading cause of debt in the US. Depending on which survey you look at, 25% to 41% of Americans have medical debt. This is in part due to the very expensive medical care in the United States and in part, to the lack of insurance available to most workers.

According to the Consumer Finance Protection Bureau, "Medical bills are the most common collections item on people's credit reports and show up on 43 million credit reports." As of January 1, 2022, medical debt under $500 is no longer allowed to be reported to the big three credit bureaus.

Advantages and Disadvantages of Unsecured Loans

Unsecured loans can be used for almost anything from paying off other debt to going on vacation, to starting a business. There are some very good reasons to consider unsecured loans.

The pros include:

• No Personal Property Risk - if you default on your unsecured loan, the lender cannot seize personal assets.
• Simpler Application Process - the lender usually looks only at your credit rating and credit history along with proof of income.
• Discharged in Bankruptcy - if you should end up declaring bankruptcy, you may have unsecured loans discharged as part of the proceedings.

The cons include:

• Possibility of Getting Sued - if you default on an unsecured loan, you have a greater chance that you will be sued to recover the amount of the loan.
• Interest Rates are Higher - because there is nothing securing the loan, you will end up with a higher interest rate than with secured loans.
• Loan Amounts are Smaller - unsecured creditors are not going to loan out a lot of money without some guarantee that it will be repaid. The average request for a personal loan amount ranges between $2,000 and $25,000.
• Your Credit History and Credit Scores Matter - if you have less than good scores, you will pay more for an unsecured loan.

Types of Secured Debt

Secured debt is any loan that is backed by an asset. Mortgages and car loans are the two most common, but you can back a loan with any asset of equal or greater value. For instance, if you own valuable artwork, you can back a loan with that artwork.

If you fail to repay a secured loan, you may lose the backing asset or collateral.

Business Loans

Business loans are taken out to start, expand, or shore up a business. These can be secured and unsecured debt. Secured business loan collateral is usually business assets.

Business credit cards

Business credit cards are issued to business owners and generally come with higher credit limits, rewards, and the ability to manage spending and linked employee cards.

Examples of unsecured debt

Examples of unsecured debts include credit card debt, medical bills, personal loans, and some student loans.

What happens if you don't pay unsecured debts?

If you do not pay unsecured loans, one of two actions will be taken. Your debt may be sent to collections or sold to a debt collection agency. You will then have all the headaches of dealing with debt collectors. This action will appear on your credit history.

Other unsecured creditors may choose to sue you in court to recover the outstanding debt. This action will also appear on your credit history. In addition, this is a public record, so people can easily discover the terms of the lawsuit.

Impact of Unsecured Debt on Your Credit Score

Your credit score is an essential part of your financial health. It's what lenders use to determine your creditworthiness, or how likely you are to repay borrowed money. One important factor that affects your credit score is your debt, including unsecured debt. Let's look at how this works:

Credit Utilization Ratio: This is the amount of revolving credit you're currently using divided by the total amount of revolving credit you have available. For example, if your credit card limit is $10,000 and you have a balance of $3,000, your credit utilization ratio is 30%. A high ratio can negatively impact your credit score because it suggests to lenders that you're overly reliant on credit.

Payment History: Your payment history is the record of whether you've paid your bills on time. If you've missed payments on your unsecured debts, it can negatively impact your credit score. It's crucial to make sure you're making at least the minimum payments on all your debts each month.

Debt-to-Income Ratio: This is the ratio of your monthly debt payments to your monthly income. If you have a high debt-to-income ratio because of large unsecured debts, it may lower your credit score and make it harder for you to get approved for new credit.

Defaulting on Unsecured Debt: If you default on an unsecured loan, it will likely be reported to the credit bureaus. This can significantly impact your credit score. If a debt goes into collections or you're sued for the debt, this will also show up on your credit report.

To improve a credit score that's been impacted by unsecured debt, consider the following:

1. Pay down your balances: Try to pay off your debt or at least lower your balances. This will decrease your credit utilization ratio and improve your credit score.
2. Make payments on time: Pay all your bills on time. If you're having trouble remembering when each bill is due, consider setting up automatic payments.
3. Don't close old credit card accounts: The length of your credit history is another factor that affects your credit score. If you pay off a credit card, consider keeping the account open to maintain a longer credit history.
4. Seek help if needed: If you're having trouble managing your unsecured debt, consider seeking help from a credit counseling agency. They can help you develop a plan to manage your debt and potentially negotiate with your creditors on your behalf.

Remember, improving your credit score won't happen overnight, but every step you take towards reducing your debt counts. Stay consistent, and over time, you'll see improvements.

Choosing between secured vs. unsecured debt

Secured and unsecured debt both have pros and cons. Which you choose depends on the pros and cons, how much you want to borrow, and how willing you are to either have an asset repossessed or end up in collections or court if you fail to repay the loan.

How to pay off secured and unsecured debts

Prioritize paying off secured debt. Do not take out more debt. As you free up cash, repay the highest interest rate unsecured debt until you have paid off that debt. Do not keep adding to the debt by continuing to use credit cards or taking out additional credit cards.

Debt Management Strategies

Managing debt, particularly unsecured debt, can often feel overwhelming. However, there are several strategies that can help you reduce your debt and regain control of your financial situation. Here are a few methods to consider:

Debt Snowball Method:

This method involves focusing on paying off the smallest debts first while making minimum payments on larger ones. As each smaller debt is paid off, the money that was used for those payments is then applied to the next smallest debt. This process continues until all debts are paid off. The idea behind this method is to create psychological wins by eliminating smaller debts quickly, which can provide motivation to keep going.

Debt Avalanche Method:

This strategy involves paying off debts with the highest interest rates first, regardless of the debt size. By tackling high-interest debts first, you may save money over the long run. However, it may take longer to pay off individual debts compared to the snowball method, which can make it harder to stick with.

Debt Consolidation:

This involves combining multiple debts into a single debt that has a lower overall interest rate. This can simplify the repayment process by reducing the number of payments you need to keep track of each month. It can also potentially save you money on interest over the long run.

Credit Counseling:

If you're feeling overwhelmed by your debt, consider seeking help from a credit counseling agency. Credit counselors can provide advice on managing your money and debts, help you develop a budget, and usually offer free educational materials and workshops.

Remember, the best strategy for you will depend on your personal situation and preferences. What's most important is choosing a strategy that you can stick with until all your debt is paid off. You may also want to consult with a financial advisor or credit counselor to discuss your options.

Unsecured Loan Borrowing Methods

If you want to take out an unsecured loan, check your credit history. If there are errors, have them corrected as soon as you can. If your credit score is less than good, spend some time (like 6 months to a year) repairing your credit rating by paying your bills on time every month and paying down your credit cards.

Next, look for loans with the best terms. These may be through a local credit union or even an online lender or P2P organization.

If you must, look for a co-signer with better credit. If someone asks you to co-sign on a loan, ask if you can repay the loan if/when the person defaults. Otherwise, you will end up with damaged credit.

Have a plan to repay the loan and be able to afford the loan.