What is a good unsecured debt?

There are many different ways to borrow money, from a simple IOU sealed with a handshake to a complex business borrowing instrument like a subordinated convertible debenture. Fortunately, nearly all borrowing can be conveniently divided into two types of debts: secured and unsecured.

The difference between the two types of debt is relatively straightforward. A secured loan has collateral, and an unsecured one does not. Collateral is an item of value that a borrower offers to a lender as security on the loan. If the borrower doesn’t repay the loan, the lender can seize the collateral and sell it to recoup all or part of their loss.

Whether a debt is secured or unsecured is important for many reasons. It often has a significant impact on the loan’s cost. It can influence whether you can get credit. And the wisest strategy to follow when paying off debt, or the order in which you’ll repay your debts, is often determined by whether a debt is secured or unsecured.

Here’s more on the differences between secured and unsecured debt.

Unsecured debt is money that’s borrowed without collateral. For example, if you forget your wallet at lunch and ask a colleague to pick up your check with the promise that you’ll pay them back when you return to the office, that’s generally an unsecured debt. Your promise to repay is the only guarantee your coworker has of getting their money back.

With unsecured debts, lenders can’t rely on the presence of collateral as a way to reduce risk and reassure themselves that they’ll get paid. Instead, lenders typically look at a borrower’s creditworthiness to decide whether to extend an unsecured loan. This generally involves examining a borrower’s history of borrowing and paying back money. Lenders may also look at the borrower’s income to predict if there is sufficient income to make payments on the loan.

Here are some other examples of unsecured debts:

Some additional kinds of transactions are also similar to unsecured loans. For instance, when you sign a contract to belong to a gym, you promise to pay the monthly membership fee for the length of the contract. However, the gym doesn’t get any collateral. Utility bills and taxes are other examples of unsecured loans.

If you invest in a corporate bond, you are giving the bond’s issuer an unsecured loan. Similarly, United States Treasury bills are loans to the federal government that are secured only by the government’s promise to pay.

Finally, some financial instruments are not entirely secured but have some security. For instance, a bond is a debt security issued by a corporation that can be converted at the holder’s option to shares of stock. The convertible subordinated debenture mentioned at the start of this article is an example of that kind of convertible debt.

The key feature of a secured debt is that the borrower has put up collateral. This is an asset that the lender can, if the borrower defaults on the loan, repossess. Loans can be secured by all types of assets, including real estate, vehicles, equipment, securities and cash.

Common examples of secured debts include:

With a mortgage, the loan is secured by real estate. If the borrower fails to make the payments, a home mortgage lender can foreclose on the home and sell it to recoup the loaned money. Vehicle loans work the same way.

Usually, a secured debt is secured by the asset purchased by the proceeds of the loan. A car loan is secured by the car. Sometimes, the proceeds of the loan may be used for some other purpose. For instance, you could use money from a home equity loan or home equity line of credit to pay off an unsecured credit card or medical bill.

Generally, the borrower explicitly agrees to put up the collateral as security. However, there are loans that don’t identify any collateral up front that can result in collateral being seized in the event of default. For example, if a homeowner fails to pay property taxes, the taxing authority may obtain a tax lien against the home. If the taxes aren’t cleared up, the home may be seized and sold to pay the tax bill.

The presence or absence of security makes a big difference in many aspects of borrowing. Below are some of the key pros and cons of secured and unsecured debt.

Smart borrowers clearly consider whether a debt will be secured or unsecured before borrowing. But presence or absence of collateral also figures when deciding how to repay existing debts.

One recommended approach is to pay off the debt with the highest interest rate first. This is sometimes referred to as the debt avalanche method. Generally speaking, this often means concentrating on paying off unsecured debts before paying off secured debts.

The debt snowball method takes a different approach. With this method, you generally focus on paying off the smallest amount of debt first in a short period of time while still making payments on your other debts, to help generate momentum toward repayment.

Sometimes it’s better to prioritize needs. For instance, if you lose your job and have to choose between paying the mortgage and making extra payments on a credit card to reduce the high-interest balance, it may make more sense to pay the mortgage first. In the case of an either-or decision, ensuring you have shelter takes precedence.

Similarly, if you need your car to get to work, you may elect to make sure the car payment is made before the personal loan payment, even if the personal loan carries a higher interest rate.

If you find you need help with managing your secured or unsecured debts, debt relief can take different forms, and one may work better than another for your financial situation. Make sure to explore all of your options before deciding on a method.

Unsecured and secured debts both involve a promise to pay, but one carries significantly more substantial penalties if that promise isn’t fulfilled. You may be able to get more credit by using secured credit, and the cost may be less as well. But unsecured credit also has some advantages.

Unsecured debt is a debt in which the borrower does not provide collateral against the loan. Unsecured debt exposes the lender to credit risk, because in case of default by the borrower, the lender has no collateral to recover the borrowed amount from. The unsecured debt is risky, in turn, commands a higher interest as compared to secured debt which is secured by collateral.

Lenders may sue the borrower to receive access to some assets, if the borrower refuses to pay the amount back.

·       Credit Card debt: Credit card debt forms the most widely spread form of unsecured debt. One thing to remember is that all the credit cards are not unsecured. There are some secured credit cards that require an initial deposit equal to the spending limit.

·       Personal loans debt: Personal loans are funded by banks and usually have a cap. It can be used for a variety of purposes ranging from a vacation to funding a start-up.

·       Private student loans: These loans are another example of overwhelming debt. These debts provide students with opportunities to learn and concentrate on their studies.

·       Peer to peer loans: These loans are provided to one individual by another. These loans often happen between family members, relatives and friends.

·       Medical Debt: Medical bills are a very unique type of unsecured debt. In other forms of debt, a person usually decides to do something that requires debt but nobody wants to fall ill and get stuck under medical debt.

·       Apartment Leases: When one falls behind in paying his/her rent, he/she gets indebted to the landlords. Landlord may decide to take action against you. But since no asset of yours is at risk, this debt comes under unsecured debt.

As mentioned earlier, unsecured debts are those debts which do not have any asset backing them up. In contrast secured loans are those loans that are backed by an asset or a collateral. Secured debts are less risky but usually they offer less returns than unsecured debts.

Advantages and disadvantages of unsecured loans can be described once we define whose perspective we are referring to. From a lender’s perspective, the biggest disadvantage is lack of collateral from the borrower. But unsecured loans also offer more return to the lenders and lenders can mitigate risk by properly analysing the financial background of the borrower. Even then, if the borrower defaults, lenders have an option to sue him/her and get access to some assets or accounts.

From a borrower’s perspective, the pros and cons of unsecured loans are:

Pros:

·       Shorter repayment term

·       No asset risks

Cons:

·       Harder to get from the lenders

·       Higher interest rates

·       Generally lower borrowing amount allotted

• Personal loans.
• Overdrafts.
• Utility bills.
• Credit cards.
• Payday loans.

Examples of unsecured debt include credit cards, medical bills, utility bills, and other instances in which credit was given without any collateral requirement.