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Unsecured Debt

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Claire Matthews

Financial Advisor, DCL

Unsecured Debt

In a perfect world, people won’t need to borrow money. However, the reality is that no matter how efficiently individuals try to manage their finances, there will be challenging situations. These could be unforeseen emergencies, sudden trips, or life-changing events such as moving out of your parent’s home, or quitting your job. It could be anything, really and it can happen to anyone.

 

Even people who are careful with their money and diligently set aside money in the bank, may be placed in a situation like this. If it happens once or twice, it’s perfectly all right. The point is being able to pay back the amount owed within the specific period in order to prevent interest and penalties. If the term of your loan or cash advance was for three years and you were able to make all your payments religiously, there won’t be any problem. You will have a good credit rating and you will be considered a good creditor by financial institutions. Problems arise when payments are missed and penalties and surcharges are added to the original sum owed.

Borrowers who are delinquent in their payments will have a hard time taking out loans or cash advances again.

Debt has always been as sure way to access quick cash, but it is important to be mindful of what you owe and when you are supposed to pay the money back.

What is Unsecured Debt?

Unsecured debt is a debt where the basis of qualification for its obtainment is your creditworthiness. Influenced by your ability to make the monthly payments in similar transactions, your credit score becomes the primary basis of the monetary value of this unsecured debt will be awarded to you. The only physical requirement demanded would be the signature on the contract, thus the moniker “signature loans.”

Just like the name implies, unsecured debts don’t require the borrower to put down property or possessions as collateral for the loan. They also don’t need to undergo credit checks or background investigation before the loan is approved. Lastly, there’s no need for another person to co-sign the loan. These sums of money are lent to people on the basis of pure goodwill.

Secured vs. Unsecured Debt

Comparing it with its polar opposite, there are three salient differences of unsecured debt to secured debt.

  1. Collateral

Collateral is a form of security for your debtors, basically a property or anything of value that they will acquire in case you fail to make your monthly debt payments. From the word, secured debt requires collateral.

Because a house or a car is the most common valuable possession one has, it is the usually put up as collateral to obtain funds.

For most personal loans, the most common form of collateral is your home or your car. These items are generally the most valuable possessions a person owns; thus they are the items put up first by consumers in an attempt to secure funding.

The disadvantage of secured loans is that should the borrower default on his payment, the bank or financial institution has the right to seize the property listed as collateral. This is a dangerous gamble, especially if it’s the family home that has been placed as collateral. Should anything happen to the borrower and the family members are unable to pay the debt, they will also end up without a roof over their heads.

  1. Monetary Amount Credited

There are numerous factors that ultimately determine the final amount. Generally, a person gets a secured debt for high amount of loans, because the creditors “match” the value of collateral. For unsecured debt, the amount they may be willing to award to you varies but will be definitely be smaller.

  1. Credit Score

While unsecured debt is considered riskier than secured debt, credit score still matters for both cases. The difference, however, is that the former would be more difficult to secure with poor credit ratings.

  1. Interest Rate

All things held equal, set interest rates are relatively more relaxed for secured debt than for unsecured debt.  Interests are higher for loans without collateral, prior credit investigation or co-signer because the banks are assuming a higher risk in lending money to the borrower.

Five Common Forms of Unsecured Debt

  1. Credit card debts

Being the most common form of unsecured debt among all five listed here, credit card debts total at around $779 billion or an average of $16,748 per household in the U.S. alone. It is difficult to get out of credit card debt due to high interest rates, which goes even higher when you miss payments.

  1. Personal and business loans

Some personal and business loans do not require collateral, making them a form of unsecured debt. This can be money that you borrow from friends or family or people who lend money with a small interest. In some cases, small cooperatives can also fall in this category because they don’t require collateral before lending individuals money.

  1. Student loans

Student loans are generally unsecured as those who aspire to get a degree do not have any property they can put up as collateral. They are, however, bound by contracts that require them to pay the money they borrowed once they have graduated and become employed. Student loans can add up to a big amount of money and cause a big strain on the population. The good news is, once these loans are paid up in full, the borrower is free from debt and can start enjoying the fruits of his labors.

  1. Medical loans

Medical debts are considered unsecured debt which a person gets especially for paying hospital bills.

  1. Unpaid house bills

Among all five, this is the only one you do not need to apply for. Once a bill goes unpaid, it becomes essentially an unsecured debt. While there are consequences of your inability to make the payment like eviction, your creditor would not be able to seize your assets.

What are the Pros and Cons of Incurring Unsecured Debt?

Pros

No Collateral

With unsecured debt, you do not place yourself at a risk where you can lose a valuable property. You will keep all your assets intact, but failure to pay will definitely drop your credit rating. Moreover, you may never be able to secure a loan again without a sizeable collateral.

Easier Application Process

There are forms of unsecured debt which you can get without much hassle. For example, student loans are very easy to apply for despite their target market having virtually no asset. Having no collateral to add to the equation smoothens the process.

Cons

Harder to Get Approved

Without collateral to soften the risk of lending, creditors do not offer unsecured loan to everyone. In the event that it to you with bad credit rating, expect exorbitant fees and unreasonable interest rates.

Less Money at Higher Interest Rates

As already discussed, unsecured loans are riskier for the creditors. Thus, you pay for this risk through higher interest rates. They may not also be willing to loan you a high amount because it is not the best decision for them in the economic sense.

As a result, you get to pay more for less money that you owe.

Why Do Creditors Offer Unsecured Debt?

In a perfect and risk-free world, everyone would have collaterals which they can use for the loan. However, there are some people who have no valuable asset in need of money. This reality opened up a new profiting opportunity for creditors everywhere.

Despite the higher risks, unsecured debt is still more profitable for the creditors. As people are attracted to the fact that they are not risking material property in exchange for the loan, there is also a big market for it.

How Do Creditors Assess Risk when Deciding on Awarding You Unsecured Debt?

Creditors look at a wide variety of factors to determine whether to offer you unsecured loan. These five criteria are also the basis of how much money they would be willing to risk. They are the “five C’s” of credit: character, capacity, capital, collateral, and conditions. As we are discussing unsecured debt, the fourth C (collateral) becomes irrelevant.

Character

One of the factors looked into before approving or rejecting your loan, character here means your debt payments behavior in the past. They determine this by checking your credit history. Other related financial activities such as foreclosures and bankruptcies also fall under this criterion.

Capacity

To evaluate the probability of you making the payments, lenders look at your capacity to pay off the debt. Here, they will assess your income per month and its stability against the amount you want to borrow.

Capital

Capital is the money you have which you can use to secure the first payment of the loan. For example, banks are more likely to offer a credit card to a client with a high account balance compared to someone who is only maintaining the minimum amount required.

Conditions

Everything that concerns the agreement with between the lender and the debtor. This includes the reason behind taking out a loan, the interest rate, as well as the amount to be loaned.

Is There Ceiling for Unsecured Debt That You Can Incur?

Technically speaking, there is no set ceiling of unsecured loan which you can avail of. For as long as a creditor is willing to award you the loan, the ceiling goes higher.

However, if you have too much debt, you will not be eligible for some forms of bankruptcy. For Chapter 13 bankruptcy, the limit for unsecured debt as of April 1, 2016 is $394,725. Your unsecured debt is not considered a factor at all, on the other hand, when filing for Chapter 7 bankruptcy.

Of course, it is still best to consult a professional regarding your options before crossing it off the list.

What Happens to Unsecured Debt When You Die?

There are different regulations on what will happen to your unsecured debt in the event of your death depending on its type as listed above.

Credit Card Debt and Student Loans

Credit card debt, which what you know now as the most common form of unsecured debt, still needs to be settled even if you pass away. All the assets you leave behind such as your car, your house, and your stocks will be used to pay your debts. If these are valued less than the total amount you owe, there are no other ways for your creditor to seek the remainder of the payable sum.

The recourse will be different, however, if there is a joint account holder on the card or if you live in a “community property state.” In this case, your spouse or other living member of your immediate family will inherit the debt.

For student loans, there are similar but relatively more relaxed rules. Like in dealing with credit card debt, the borrower’s estate will be utilized to pay for the amount due until all assets and resources are exhausted.

After assets have been turned over, some of the biggest private lenders simply “forgive” the debt. That is only applicable, however, if do not live in a community property state.

Else, as with credit cards, your spouse or any member of immediate family will now be held responsible for repaying the rest of your loan.

What Can You Do If You Cannot Secure the Payments on Your Own?

The responsible thing to do is simply bite the bullet and continue with the payments as agreed by you and your creditor. Sometimes, certain unexpected events such as accidents or job loss may not make that possible.

Here, you have no choice but to explore other options such as debt consolidation. However, if at all possible, avoid unsecured debts or any kind of debt for that matter to ensure financial health and to enjoy life without creditors on your back.

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