Unsecured loans are considered to be riskier for the lender, and generally have higher interest rates than secured loans. Let’s see next what is an unsecured debt.
What is an unsecured debt?
Unsecured debt refers to loans that are not backed by collateral. If the borrower defaults on the loan, the lender may not be able to recoup its investment because the borrower is not required to pledge any specific assets as collateral for the loan.
Because unsecured loans are considered riskier for the lender, they generally carry higher interest rates than secured loans.
- Unsecured debts are loans that are not secured.
- They generally require higher interest rates because they offer the lender limited protection against default.
- Lenders can mitigate this risk by reporting defaults to credit rating agencies, hiring credit collection agencies and selling their loans on the secondary market.
Understanding Unsecured Debt
A loan is unsecured if it is not backed by any underlying asset. Examples of unsecured debt include credit cards, medical bills, utility bills, and other instances where credit was extended without any collateral requirements.
Unsecured loans are particularly risky for lenders because the borrower may choose to default on the loan through bankruptcy. In this situation, the lender may try to sue the borrower for repayment of the loan. However, if specific assets are not pledged as collateral, the lender may not be able to recoup their initial investment.
IMPORTANT: Because unsecured loans are considered riskier for the lender, they generally carry higher interest rates than secured loans.
Although bankruptcy may allow borrowers to avoid paying their debts, it is not without its consequences. Borrowers who have filed for bankruptcy in the past may find it difficult or impossible to obtain new loans in the future, as bankruptcy will have a severe negative impact on their credit score, likely for many years to come.
Meanwhile, lenders may seek alternative methods to recover their investment. In addition to suing the borrower, lenders can also report any instances of default or delinquency to a credit rating agency. Alternatively, the lender may also contract with a credit collection agency who will then seek to collect on the unpaid debt.
What is Unsecured Debt (Real World Example)
Max is a private lender specializing in unsecured loans. He is approached by a new borrower, Elysse, who wants to borrow $20,000.
Since the loan is not guaranteed, Elysse is not required to pledge any specific assets as collateral in the event of loan default. As compensation for this risk, Max charges you a higher interest rate than the rates associated with secured loans.
Six months later, the loan becomes delinquent due to a series of late payments on Elysse’s part. Max has several options to consider:
Although Max could try to sue Elysse for repayment of the loan, he suspects that this would not be worth it because no specific assets pledged as collateral. Alternatively, you choose to hire a collection agency to make the loan payment on your behalf. As compensation for this service, Max agrees to pay a percentage of any amount the collection agency is able to recover.
Another option: Max could have sold the debt to another investor using the secondary market. In that scenario, it would likely have sold the debt at a substantial discount to face value. In exchange for the discounted purchase price, the new investor would bear the risk of not being reimbursed.