Unsecured debt: what it is and how it works

Learning about money means you're ready to take more control of your financial destiny. Breaking down financial terms is a great place to start. 

Unsecured debt is an important piece of life’s financial puzzle. Let’s talk about what it is, how it’s different from secured debt, and why it matters.  

Understanding unsecured debt

Unsecured means the debt isn’t backed by collateral. Collateral is something of value you own, like a home or a car, that you pledge as a guarantee that you’ll repay the debt. Lenders can ask for collateral when someone applies for a loan. If a borrower takes out a loan and doesn't pay it back, the lender can keep the collateral to recover what's owed. That helps the lender manage risk. 

For unsecured debt, such as an unsecured personal loan, you won’t pledge any collateral to the lender. Instead, they’ll look at your credit standing, your history of repaying debts, your income, and other details in your financial picture to decide whether to give you the loan. 

The higher your credit score, the higher the chances are that you may get approved for unsecured credit accounts. At the same time, getting an unsecured loan affects your borrowing potential until you pay off the loan, bring in more money, or both.

Unsecured debts have higher interest rates, on average, than secured debts, because there's no collateral for the lender to fall back on.   

Types of unsecured debt

The most common examples of unsecured debt include:

• Credit cards. Credit cards offer access to a revolving credit line. As you make purchases, your available credit decreases; as you make payments, your available credit goes back up.

• Personal loans. Personal loans let you borrow a lump sum that you repay over time, with interest. As long as you make your scheduled payments on time, a personal loan balance only goes down, since the entire amount is issued in one lump sum when you get the loan—and then you pay it off with regular payments, or installments. 

• Student loans. Student loans for college and grad school are unsecured, whether they are issued by the government or by a private lender. 

• Personal lines of credit. A personal line of credit lets you spend money against your credit limit using a debit card or paper checks. You pay interest only on the amount of your credit limit you use. The way it works is similar to a credit card.

Some of these debt types are also available as secured debts. For example, if you're new to building credit, you might start with a secured credit card. This kind of credit card usually requires a cash deposit to open. You may get the deposit back after making a number of on-time payments. 

Secured personal loans and secured personal lines of credit may use a savings account or a car title as collateral. 

These options are usually designed for people who are new to using credit, or are trying to rebuild a credit score. 

Managing unsecured debt

Paying down unsecured debt is important if you have other financial goals to work toward. Effective debt management starts with finding the repayment strategy that works best for you. That might start with choosing the debt to pay down first.

There are different ways to prioritize debt, according to your goals. You might decide to pay off the ones with the highest interest rates first using the debt avalanche method, which is designed to save you the most in interest.

The debt snowball, meanwhile, has you pay off debts from the lowest balance to the highest. This method helps motivate you to keep going, offering milestones as you clear a smaller debt or two quickly. 

Or you might simply target the debt that's bugging you the most. If your student loans have hung around for years, for example, you may be fed up and ready to ditch them for good. 

Looking at your current debt balances, monthly payments, and interest rates can help you decide what to prioritize. You can also use a debt payoff app to come up with a repayment plan.

What happens if you default on an unsecured debt?

Defaulting on a debt means you stop making payments. If you default on a secured debt, the lender can take your collateral. 

Unsecured debts are different. After repeated missed payments, your lender might first try reaching out to you to request that you pay. If those requests go unanswered, your debt might be assigned or sold to a debt collection agency. 

That usually means more phone calls or letters requesting payment. Eventually, the debt collector or original creditor may decide to sue you for payment. If a creditor wins a lawsuit against you, they could get a court order that allows them to withhold part of your wages or take money from your bank account. 

Throughout this process, your credit report is very likely to suffer because of the late and missed payments. 

All of the above are good reasons to seek help with your debt. 

Seeking professional assistance for unsecured debt issues

It's okay to ask for help with debt—a professional might point out solutions you've overlooked. 

Some options for getting help include:

• Credit counseling

• Debt resolution

Credit counseling agencies are usually nonprofit organizations that offer people advice on budgets and debts. 

Debt resolution is the process of negotiating with your creditors to accept less than the full amount you owe but consider it payment in full. You can negotiate with creditors yourself or work with a professional debt resolution company that can negotiate on your behalf. 

Talking to a debt expert can help you decide on the best way to handle your debt situation. 

What's next

• If you’re considering applying for credit, think about why you need to go into debt. An unsecured debt is tempting because you don’t have to offer collateral. But it’ll usually cost more than a comparable secured debt. Both options are worth researching.

• Create an inventory of what you owe, including balances and interest rates. 

• Get advice from a debt expert if you’re not sure how to organize or manage your debt.