Unsecured debt refers to debt that doesn’t require the borrower to offer up collateral. Lenders offer unsecured loans based on a borrower’s promise to repay, as well as their credit history or ability to repay the debt.
A Better Understanding of Unsecured Debt
To better understand unsecured debts, it will be helpful to dig deeper into how they work for borrowers and lenders.
For a borrower, unsecured debt can depend mainly on credit scores. And so, borrowers with less-than-good credit may find it challenging to get a large loan amount or approval at all. The good news is that a cosigner can be added to unsecured loans for better chances of approval.
For unsecured creditors, their loans are a considerable risk. This is because if a borrower fails to repay the loan, then there really isn’t any upfront security that secured debt does have. And in the event that the borrower files for bankruptcy, the unsecured debt is usually discharged.
Despite this risk, unsecured debts usually have a lower interest rate than secured loans simply because secured loan lenders will risk lending to subprime borrowers, while unsecured debt lenders will not take that risk. And so, because they only work with fair to good credit borrowers, chances are that they will get their payments on time.
Examples of Unsecured Debt
Some examples of unsecured debt include credit cards, personal loans, medical bills, utility bills, and federal or private student loans.
Credit cards are a form of revolving credit that you can borrow from multiple times before reaching your credit limit. Once you get to that credit limit, you can make a payment on your card, and you will be able to use it again. With a standard credit card, you won’t need to provide any collateral for funding, making it a form of unsecured debt.
A personal loan is one of the most common loan options out there. For these, you will get a lump sum amount that you can use immediately or allocate over time if needed. The flexible thing about unsecured personal loans is that you can use the funds for almost any kind of expense. Just like a standard credit card, a standard personal also doesn’t require collateral, making it a form of unsecured debt.
Medical debt and utility bills are pretty straightforward; medical debt is any bill you get after seeking medical care. A utility bill is any bill you get for household utilities like gas, electricity, and water. Unlike credit cards or personal loans, you get a service or care rather than money upfront, which you will have to pay for later. These are classified as unsecured debts because they will be a part of the outstanding debt that gets discharged in the event of bankruptcy.
Student loans (private and federally funded) provide funding for students who need to pay for their college education. With these unsecured loans, students can usually defer loan payments until after graduation.
Examples of Secured Debt
To better understand unsecured debt, it may be helpful to see some examples of secured loans. Some examples of secured loans are auto loans, home equity loans, and mortgages. With a car loan, the collateral is a vehicle; for a home equity loan and mortgage, the collateral is real estate.
How Can Unsecured Debt Impact Credit?
Unsecured debt can definitely impact your credit scores from all three major credit bureaus. Here are a few different ways that unsecured debt can affect your credit score:
Payment History
Your payment history is the most significant factor impacting your credit scores. And so, once you begin repaying your unsecured loan, that payment history will appear on all your credit reports. Any missed payments that are made late will have a significant negative impact on your credit score. While on-time payments will help your scores.
Your Debt-to-Income Ratio
Your debt-to-income ratio is another factor that can affect credit. When you add debt to your credit portfolio, it will increase this ratio. A ratio that is too high can hurt credit scores, while adding a loan to a portfolio that doesn’t have much with it may help.
Your Credit Utilization
Your credit utilization measures the amount of debt you have against your available credit. Adding a new loan to your credit history can increase that ratio, and anything over 30% can be harmful. So consider that before taking out a new loan.
Loan Default
Loan default occurs when you have several missed payments/have delinquent debt, or if you break any terms of the loan agreement. Loan default can devastate your credit score because of the missed payments and can lead to a collections account. Having this a part of your credit history may prevent you from getting financial products and services.
How Do I Know What Type of Loan Is a Better Option for Me?
You need to make a few different considerations to decide whether an unsecured or secured loan is the right option for you. Here are some things to think about when you are trying to decide between secured and unsecured debt:
Consider What Your Buying and the Expense
The type of expense or purchase you are making should be essential in deciding the type of loan you want to take out. Specific loans work well for specific expenses. For example, an auto loan is likely your best bet if you are trying to purchase a car because these loans are tailored particularly for this purchase. Or if you have multiple bills to pay, most personal loans will work well.
Think About Whether You Have Collateral You Can Offer for Secured Loan Options
Another thing to think about is that secured debt has collateral involved. This collateral can be a car, jewelry, real estate, stocks, bonds, and even cash. If you don’t have any assets you can use, then you’ll have to stick with unsecured loans.
Consider the Costs of Unsecured Loans vs. Secured Loans
Interest rates and fees make up most of the costs you’ll see with any loan. Generally, secured debt has higher interest rates and costs compared to unsecured debt. And so, if you have the means to get an unsecured loan, start there.
Figure Out if You Can Manage Debt
Some loan options like credit cards or payday loans can quickly lead to a cycle of debt. This is especially true if you need to gain experience with debt management or aren’t truly aware of the cost of a loan before you decide to take it out. And so, before you take out a loan, make sure to understand the actual cost of it, along with educating yourself on loan repayment and managing debt.