4 Min Read | September 15, 2022
What Is Unsecured Debt?
Unsecured debt is a debt owed to a creditor that is not tied to an asset like your home or car. Here are some pros and cons of carrying unsecured debt.
At-A-Glance
There are many types of unsecured debt, from credit cards to medical bills.
Regular, on-time payments on unsecured debt can boost your credit score, among other advantages.
But because you put up no collateral, interest rates on unsecured debt can be high.
Unsecured debt is any debt that is not tied to an asset such as your home or car. This means that if you default, the lender can’t seize your assets. Any type of debt that puts your belongings at risk is secured, not unsecured. But remember, even with unsecured debt borrowers are not off the hook if they fall behind on payments – their credit history might take a hit and creditors can still pursue other remedies for repayment, so it’s important to treat unsecured debt as responsibly as secured debt.
Here’s what you need to know about unsecured debt, including its common forms, its advantages and disadvantages, and some things to consider before taking it on.
Common Forms of Unsecured Debt
There are many different types of unsecured debt. Here are some common ones:
- Credit cards.
- Personal loans, including private, family, and peer-to-peer.
- Private student loans.
- Medical bills.
Advantages of Unsecured Debt
For people with good credit scores, unsecured credit can be easy to obtain. Today’s online lenders can check credit scores in real time and approve unsecured loans in seconds.
Among the advantages of unsecured debt are:
- Flexibility: On some types of unsecured debt such as credit cards, payment terms can be reasonably flexible and may include interest-free periods. Credit cards also typically offer rewards programs or cash-back options, which can effectively reduce your cost of borrowing.
- Potential credit score boost: Regularly paying off credit card balances and staying up to date with personal loan payments can improve your credit score, making it easier to get credit in the future. If you’re just starting to build your score – perhaps because you’re a young person leaving home for the first time – you can build your score by taking out a basic credit card and using it responsibly.
- Less risk for you: Unsecured debt does not put assets at risk. If you default on your mortgage – a type of secured debt – the lender can seize your house. But if you default on an unsecured credit card or loan, the lender can’t seize your house or anything else you own. They must pursue you through the courts for settlement of the amount you owe.
Disadvantages of Unsecured Debt
Breaking the terms and conditions of an unsecured debt may hurt your credit rating. This can make it hard to obtain credit in the future. It might also affect your ability to find an apartment rental, since landlords may be wary of people with a history of default, as it can suggest financial irresponsibility.
Other disadvantages of unsecured debt include:
- Higher interest: Interest rates on unsecured loans are typically higher than on secured loans because the lender is taking on more risk.
- Penalties: On some forms of unsecured debt, the immediate penalties for default can be serious. For example, if you default on a utility bill, you could be disconnected. If you fall behind with your rent, you could be evicted. Additionally, if your lender pursues you through the courts for settlement, you may have to pay legal costs.
- No tax deductions: Interest payments on unsecured personal debt aren’t tax-deductible, whereas they sometimes are on secured debt – for example, mortgage interest is tax deductible.
Things to Consider When Taking on Unsecured Debt
Considering taking on unsecured debt? It’s a good idea to think through your reasons and create a financial plan to pay it back responsibly. Consider that you might need different types of unsecured debt for different situations. For example, you might want to use a credit card for a new couch or a vacation, but if you’re looking to finance a master’s degree, you’ll probably want a student loan.
Unsecured loans are usually paid off short term, typically within five years or less. Generally speaking, the longer the term, the higher the interest rate, so it’s worthwhile to estimate how long you’ll need this financing. How quickly can you pay off this debt without stretching your household finances too thin?
Remember that personal loans typically have fixed monthly repayment amounts. And credit cards have a minimum payment, which is a small portion of the outstanding balance. You’re obligated to make these payments every month regardless of any fluctuations in your income. An emergency fund can help you maintain personal loan and credit card repayments in the event of temporary disruption to your monthly income.
The Takeaway
Unsecured debt can help buy the things you need when you need them, without putting your assets at risk. It can also help build your credit score, improving your ability to obtain financing and even employment or housing in the future. However, unsecured debt can sometimes be expensive, and too much of it can become unaffordable. It’s wise to choose your loans and credit cards carefully and manage them sensibly.
Frances Coppola spent 17 years in the financial services industry before becoming a noted writer and speaker on banking, finance, and economics. Her work appears in the Financial Times, Forbes, and a range of other publications.
All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.
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