Unsecured Debt

Financial Dictionary -> Debt -> Unsecured Debt

Unsecured debt is a debt on which the lender does not have a lien. This means that the debt is not backed up by an item of value, usually a type of property belonging to the borrower, pledged as security to cover the outstanding balance if the borrower defaults on the loan.

Common examples of unsecured debts are credit cards, store cards, personal loans, medical bills, unsecured business loans, unsecured signature loans etc. where the borrower is not required to pledge upfront any security for the debt unlike mortgages and car loans where the property purchased is used as a lien for the loan.

For a personal unsecured loan, the individual borrower is the one responsible for repaying while businesses are responsible for the repayment of the unsecured business loans. There is also the unsecured business loan with a personal guarantee. The business would borrow money but an individual becomes responsible for repayment in the event of business defaulting on the loan. Unsecured bonds, debentures and promissory notes are also examples of unsecured debt.

All these are debt offerings backed only by the credit standing of the issuer and not secured by collateral. Since there aren't assets that the lender can take if the borrower fails to repay the loan, there is a higher financial risk for the lender.
Unsecured lenders generally have stricter underwriting rules in order to dissipate the increased risk when lending without collateral. Unsecured lenders base their decision to make a loan offer on the applicant's credit history i.e. how did he or she manage past and current credit accounts, which is deemed a sign of how likely the borrower is to repay the loan.

Interest rates are a reflection of the risk to the lender. With a secured debt, there is less risk since the lender has means to recover some of the funds it has loaned while at the same time, the borrower has incentive to make timely payments because the consequences are much harsher - the debtor can not only damage his or her credit score and credit worthiness, but faces the danger of loosing his home, car, and other valuable property. For this reason, unsecured debt usually carries a higher interest rate than secured debt.

If the borrower of an unsecured loan files for bankruptcy, the unsecured lenders can only have a general claim on his or her assets and only after the specific promised assets have been allotted to the secured lenders. In addition, the unsecured creditors typically take in a smaller share of their claims than the secured ones.

Borrowers, who have multiple outstanding debts and do not own property or are unwilling to use their property as collateral, often use the so called unsecured debt consolidation loan. In addition to avoiding having their home or car repossessed, other advantages for borrowers include fixed payment periods, quicker processing, and less documentation.