What is Unsecured Debt?

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.

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:

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.

Common myths about unsecured debt 

Several myths surrounding unsecured debt can mislead consumers:

• Myth: All unsecured debt is bad.

  • Fact: Unsecured debt can help you build a strong credit profile, get through a financial emergency, and spread out a large expense. There are many situations when unsecured debt can be a useful tool to help you reach your financial goals.

• Myth: Ignoring unsecured debt makes it go away.

  • Fact: Ignoring debt can lead to increased interest, fees, and potential legal action from creditors. If you’re struggling with your debt, it’s better to reach out for help and find a solution than put your head in the sand and pretend it isn’t there. down the line. Facing it head-on and addressing it promptly is always the best approach.

• Myth: You can't negotiate unsecured debt.

  • Fact: Many creditors are willing to negotiate payment plans or settlements if you’re experiencing a financial emergency and you communicate with them.

By separating fact from fiction, you can approach your unsecured debt with a clearer, more empowered mindset.

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. 

Legal rights regarding unsecured debt 

The Fair Debt Collection Practices Act (FDCPA) is a federal law that protects you. It sets forth certain rules that debt collectors have to follow. Here’s a quick rundown of some of the highlights.

You have the right to be informed. Debt collectors have to give you details about the debt, including how much you owe, who you owe it to, and how to dispute it. But they don’t always provide these details automatically. You might have to ask for them.

You're protected from harassment. Debt collectors aren’t allowed to call you incessantly or use threatening language. It’s illegal for them to try to bully you into paying. They can’t threaten legal actions that they aren’t planning to take. They can’t harass your friends and family. They can’t harass you on social media. 

You have the right to dispute a debt. You can ask for validation of the debt, and you should do so within 30 days of being contacted. Otherwise, the debt collector can assume the debt is valid. The collector must provide the name of the original creditor and the amount of the debt. They also have to provide details about what you owe if there were fees added to the original balance. 

You have the right to privacy. Debt collectors can’t broadcast your debt to your friends, family, or employers. They can only share information with credit reporting agencies or others who are authorized to know.

Knowing these rights could help you manage your debt situation confidently.

Emergency funds and unsecured debt 

An emergency fund could help you avoid taking on unsecured debt. Here's how it works:

• Purpose: An emergency fund is for covering unexpected expenses, such as medical bills, car repairs, or groceries after losing your job. If you have enough in your emergency fund, you could avoid relying on credit to bridge the gap. Your emergency fund is a financial cushion.

• How to build it: Start by saving a small amount regularly. Make your contribution to savings a regular part of your budget just like paying your rent or car loan. Make small, incremental goals as you work your way up to enough money that you could live for three to six months without any income. The more you earn, the longer it typically takes to replace a lost job, so high earners should save 6-12 months’ worth. 

• When to use it: Only dip into your emergency fund for true emergencies. A blown-out tire. An unexpected medical bill. Emergency surger for your pet. Avoid using this money for non-essential expenses like travel or luxury purchases. 

• Where to keep it. Your emergency has to be accessible on short notice. Don’t put it into investments (where the value could fluctuate) or a Certificate of Deposit account (where you could pay a penalty for withdrawing it ahead of schedule. Avoid accounts that pay zero or very low interest. Many online high-yield savings accounts are free, have little to no minimum opening deposit requirement, and can be electronically linked to the checking account you use everyday.

Your emergency fund is your safety net, and besides financial security, it’ll give you peace of mind.

Tips for avoiding unsecured debt

Unsecured debt usually means credit cards and personal loans. It’s a debt that isn’t tied (secured) to an asset like a car or a home (those are secured debts). 

Unsecured credit is convenient when we need to borrow for a big expense or to cover a temporary financial shortfall. But it’s easy to slip into a situation where you owe money but don’t have anything tangible to show for it.

The most important defense you have against a debt hole is your budget. A budget doesn’t have to be complicated or negative. It’s a list of your financial choices. Most of us choose to pay for a roof over our heads, but lots of other expenses are more discretionary. You can choose to buy groceries, or you can choose to dine out. You can choose to buy a new pair of shoes, or you can choose to buy two.

First, start tracking your spending. The easiest way to do this is to use your debit card for everything, and sync your debit card to a budgeting app or review your transactions by looking at your statements. 

Next, list your income and all your nonnegotiable expenses. That would include things like; 

• Housing

• Insurance

• Loan payments

• Credit card minimum payments

• Childcare

• Healthcare and prescriptions

• Child support

• Utilities

• Cell phone

• Savings

Everything else is optional, and you can decide whether (and how much) you want to spend.

Be sure that a contribution to your savings account is on your list of essential bills to pay. Once you have sufficient emergency savings, it’s easier to get through financial rough spots without relying on unsecured 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.