Key Takeaway

Unsecured debt can be termed as the ‘common man’s debt’ and an easy means to get instant financial assistance. Let's look at how taking on an unsecured debt can benefit you and what happens if things go wrong.

Unsecured debt is a type of debt where the borrower (also called the debtor) does not provide the lender (also called the creditor) with collateral against the debt.

The term ‘collateral’ here refers to an asset of the debtor which holds value.

For example, compared to when a debtor takes a secured debt, he provides the creditor with collateral as security. If the debtor fails to repay the debt, the creditor can seize and sell this collateral to collect the owed sum.

Since an unsecured debt doesn’t have collateral, the creditors rely only upon the applicant’s credit scores and financial stability. These factors are evaluated using systems like an individual’s credit history.

Here’s how lenders evaluate if you are eligible for unsecured debt:

  • A good or excellent credit score, preferably between 650 to 800 and up, is almost a surety that you’ll be granted an unsecured debt.
  • A good credit history ensures a record of paying utility bills and debts on time. Late or missed monthly payments will negatively affect this.
  • You have not applied for multiple unsecured debts within a short period.
  • A reliable and regular source of income or significant balance in your savings bank account. Plus, the DTI (Debt-to-Income) ratio.
  • You have never defaulted on a loan (secured or unsecured debt) or declared bankruptcy.
  • Ownership of valuable assets not already pledged as collateral for a secured loan (house, vehicles, gold, etc.).

Types of unsecured debt

From credit cards to predatory payday loans, borrowers have a wide variety of unsecured debt options. However, these are the most common examples of unsecured debt:

Credit Card Debts

Credit cards are the most common type of unsecured consumer debt in circulation. According to Forbes, almost 84% of U.S. adults own a credit card.

It is a revolving debt where you pay the outstanding amount in part or whole on every billing cycle.

Student Loans

A student loan is an unsecured debt students take to pay their college tuition fees.

Many of these loans are taken from federal institutions, and the rates can vary from 4.99% up to 15% for private financial institutions.

The standard repayment duration is ten years, although it can be more in a few circumstances.

Personal Loans

A personal loan is a type of unsecured loan taken by individuals to support their urgent financial needs.

For example, someone who has met unforeseen expenses (like an accident, essential renovations, medical bills, etc.) can apply for a personal loan.

Although this unsecured loan needs no collateral, the applicant must have a source of income and a good credit history.

These loans can be taken for 12 to 84 months and attract high-interest rates of up to 36%.

In case you fail to pay an unsecured debt, these are the things that follow:

  1. If you are more than 30 days late on a loan payment, the creditor contacts and reminds you about it unless you answer. The creditor can also offer a relief plan for legit reasons for the delay. 
  2. A late fee and higher interest rates on your outstanding amount. Your credit score is ruined at this point. 
  3. After 90 days of silence, the creditor shuts down the debt account and hands over the case to a debt collection agency. These debt collectors pursue the borrower with calls, and in some cases, a law suite on behalf of the creditor. 
  4. Depending on the state you live in, you can either be sued or the court can order a lien on your assets to recover the outstanding amount of your unsecured debt. If you don’t have assets, your salary may be subject to wage garnishment.
  5. In cases where recovery cannot be made due to the poor financial condition of the borrower, the creditor can write off (forget) the debt. However, such an individual will be barred from applying for loans in the coming years and also have a bad credit report.

Advantages of unsecured debt

Check out these advantages of taking a unsecured debt to decide if it’s good for you:

No Collateral

Unsecured debt is good for risk-averse people who do not want to put their assets at stake. Since you do not need collateral, you can freely trade your assets and enjoy peace of mind. However, you must ensure to repay your debt on time and close it as quickly as possible.

Easy Disbursal

These debts can be availed in as little as 24 hours, starting with the application process and getting the money in your account. Since creditors rely upon financial records and a good credit score which can be checked within minutes. The best examples of this are credit card and personal loan application procedures.

Flexibility

Unsecured debts generally offer the flexibility of repayment in short or long terms.

Disadvantages of unsecured debt

On the flip side, here are a few disadvantages of unsecured debt:

High-Interest Rates

Unsecured debts can have interest rates as high as 36% per year. The high-interest rates also make sense as they are not backed by collateral and are usually taken for a shorter duration.

Needs a good credit score

Creditors strictly require the applicant to have a good credit score and a regular source of income. If you are struggling with your credit history for any reason, getting an unsecured debt will be challenging, especially at a feasible interest rate.

How to pay off debts

Once you take a debt, you must ensure to pay it. An unsecured debt is usually more problematic than a secured debt due to the higher interest rates and a shorter repayment time frame. A good repayment plan and a few considerations like these can help you out with this.

  • Take on only what you can pay, and always look for lower interest rates. Create a proper debt management plan before taking an unsecured debt. Look at your current financials and try to project your future creditworthiness. 
  • Always maintain an emergency fund. Just a couple of missed monthly payments can start damaging your credit score. Try having a couple of months of repayments to cover for unforeseen events (like medical bills that cost out of your budget and may result in a medical debt).
  • Try to pay off the debt as quickly as possible. Dedicate a significant portion of your income towards monthly payments. 
  • If you have multiple debts (mostly unsecured debts such as unpaid credit cards or personal loans), find a debt consolidation plan to bring all of them together under a lower interest rate.

You can look at many settlement options if you face difficulties paying off your unsecured loans.

In some cases, the creditor offers a debt settlement on their terms. However, if your creditor does not allow such a facility, you can also look out for the best debt relief companies.

These companies help you negotiate a debt relief plan with your creditor and ensure your credit history is not seriously damaged.