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What Is Unsecured Debt?
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Unsecured debt refers to a loan or line of credit that isn’t backed by collateral, such as a car, home or financial account. Credit cards and student loans are common forms of unsecured debt. Some personal loans and personal lines of credit also fall into this category.
Although an unsecured loan typically comes with higher fees than a secured loan (which is backed by collateral), there is less risk involved if you fall behind on payments.
In this guide:
What is unsecured debt?
Unsecured debt is not backed by collateral. Instead, lenders look at your creditworthiness and financial history when considering you for a loan. With no need for collateral, qualifying for an unsecured debt like a credit card or a personal loan means lenders rely heavily on your credit history to determine if you’re likely to repay what you owe.
Keeping up with payments on an unsecured loan is important. Your lender will likely report missed payments to the major credit bureaus, and could also decide to take you to court to recover the debt or garnish your wages. These actions can have lingering financial consequences: A late payment, for example, may stay on your credit history for about seven years, as will a loan default.
Secured debt — like a mortgage or auto loan — is backed by an asset like a car or home. Qualifying for this type of loan is often easier for borrowers who have less-than-great credit, but your lender does have the legal right to seize your collateral if you can’t make your payments. Compared to secured debt, unsecured debt tends to come with higher interest rates, lower loan amounts and shorter loan terms.
Unsecured Debt vs. Secured Debt
Examples of unsecured debt
- Personal loans: Most personal loans are unsecured, come with a fixed interest rate and may offer qualified borrowers same-day approval. Typical loan amounts range from $1,000 to $50,000, although some lenders may offer more.
- Student loans: These loans are used to cover educational expenses like tuition and supplies. Private student loans can come with fixed or variable interest rates, while rates for federal loans are always fixed.
- Credit cards: Credit cards offer a revolving line of credit with a maximum borrowing limit and a variable interest rate. They require a minimum monthly payment if the balance isn’t paid off entirely. Carrying a balance on a credit card causes interest to accrue.
- Personal lines of credit: With this type of credit line, borrowers with strong credit can withdraw money up to a maximum limit as needed, and pay interest only on what they use.
- Payday loans: These predatory loans come with triple-digit interest rates and are repaid out of the borrower’s next paycheck. They can be a quick option for borrowers who want to avoid a credit check, but they’re often difficult to repay and can lead to a cycle of debt.
Examples of secured loans
- Mortgages: A mortgage is a secured loan used to purchase a home. Mortgages come with a financial agreement that allows the lender to take your property if you fail to keep up with payments.
- Auto loans: An auto loan can help you afford the cost of a car but uses the vehicle as collateral.
- Auto title loans: A title loan lets you borrow against the value of your vehicle’s title, the legal document that proves ownership. These short-term loans usually come with triple-digit interest rates, so many car owners end up having their vehicles repossessed.
- Home equity loans: This is a second mortgage that lets you borrow against the equity you’ve built in your home, to receive a lump sum that can then be used for other expenses. Your home serves as collateral for this loan.
- Home equity lines of credit: A HELOC lets you borrow up to a set limit during a draw period, and then repay what you owe in full or with installments. Interest rates are typically lower than for a credit card, but you’ll use your home as collateral.
- Pawn shop loan: A pawn shop loan is secured by collateral like jewelry or electronics and typically offers 25% to 60% of the item’s value. Your lender gets to keep the item if you don’t repay the loan within a set time period. The loans don’t require a credit check, but they can come with high fees.
- Secured credit cards: This type of credit card requires a security deposit — usually a few hundred dollars — which, in turn, determines your credit limit. The cards are designed to help you build credit, with minimal risk to lenders.
How lenders evaluate borrowers for unsecured debt
To make sure you’re eligible for an unsecured loan, lenders typically check to make sure you have a history of on-time payments, enough income and assets to repay the loan and a low debt balance compared to your overall credit limit. These factors will also determine the APR you receive.
For the best rates on an unsecured personal loan, you will most likely need good-to-excellent credit, meaning a credit score of at least 680 — though 720 or higher can typically get you the best rates. With less-than-great credit, you may still qualify for an unsecured loan, but your interest rate will be higher.
If you can’t meet requirements on your own, some lenders allow you to apply with a cosigner. Here is what lenders look for in particular:
To lenders, your credit score is a measure of how well you handle money. The FICO scoring model is the most popular kind of credit score among lenders, and is determined by the following factors:
- Payment history, or the share of payments made on time (35%)
- The amount of outstanding debt you have (30%)
- The length of your credit history (15%)
- How often you’ve applied for new credit (10%)
- Whether you have a healthy mix of different types of accounts (10%)
Debt-to-income (DTI) ratio
Your DTI represents how much you owe versus how much you earn. To see your ratio, divide your monthly debt by your gross monthly income. Lower is always better, and many lenders look for DTI ratios of less than 36% when approving a borrower for a loan.
To ensure you’ll be able to make your debt payments, lenders will look at how much you earn monthly.
To determine your financial resilience in case you lose your income, many lenders will also look at your overall wealth, like any savings, investments or other assets you have.
Unsecured vs. secured debt: Which should you pay off first?
Whether you have unsecured or secured debt, falling behind on payments can have severe financial consequences. But if you’re unable to afford all your payments, you might be wondering which type of debt to prioritize.
It often makes sense to prioritize your secured debt to avoid losing your assets. If you’re struggling to balance your mortgage with other loan payments, for example, you likely want to stay current on your mortgage so you don’t lose your home.
If, on the other hand, you’re dealing with a costly car loan, you might be better off selling your car and replacing it with a cheaper one. While you’ll have to sacrifice that asset, you might get a vehicle that better fits your budget and allows you to stay up to date on your other debts.
Another debt repayment strategy to consider is the debt avalanche, which has you prioritize debts with the highest interest rate. By targeting high-interest debts first, you’ll save more money on interest charges.
This strategy is different from the debt snowball, which has you prioritize debts with the smallest balances so you can achieve some quicker wins from paying off a debt completely before moving on to the next.
Note that both the debt avalanche and debt snowball methods assume that you’re keeping up with the minimum payments on all your debts. You’re simply making extra payments on certain debts first to get to balance zero faster.
Is unsecured debt right for you?
Whether it’s secured or unsecured, you should only agree to a loan you are certain you can pay back on time, without incurring late payments.
If you’re borrowing money to purchase an asset such as a car, you’ll generally get lower interest rates and more favorable terms if you choose a secured loan. It can also make sense to choose a secured personal loan if you have poor credit, since it will likely come with a lower interest rate than an unsecured personal loan.
With credit cards, fees are usually higher for secured cards and credit limits are lower, so it might be better to opt for an unsecured credit card, provided you qualify.
If you’re unsure of what to do, consider going through the prequalification process and comparing interest rates across lenders. This will help you determine whether an unsecured loan is an affordable way for you to get the money you need, based on your financial circumstances and how much risk you’re willing to take on.
This guide explains how to prequalify for a personal loan without affecting your credit score.