Understanding its benefits and the unique challenges it poses.
Unsecured debt comes from a loan or credit line that requires no collateral. This includes personal loans and Lines of Credit (LOCs), as well as most credit cards. These types of credit offer some distinct advantages. However, they also present some unique challenges for your budget.
Secured vs unsecured
Secured debt requires collateral. You must give the creditor some type of tangible asset that can be liquidated if you don’t pay the debt. In many cases, the collateral used to secure the loan is the property you purchase with it.
- A home secures a mortgage
- A car secures an auto loan
Your primary residence also can secure a home equity loan or Home Equity Line of Credit (HELOC). For secured credit cards, the collateral used to open the credit line is a small cash deposit.
By contrast, unsecured debt has no collateral. There is no tangible asset that the creditor has the right to sell if you fail to pay what you owe. If you default on an unsecured debt, the creditor must file a lawsuit against you. If they win the lawsuit against in your court, they could obtain a Writ of Execution. Only then would they be legally permitted to seize your property to recoup their losses.
Types of unsecured debt
There are three basic types of unsecured debt.
By far, the most widely known and widely used type of unsecured credit are credit cards. If you’ve never heard of unsecured credit cards, that’s because almost all credit cards are unsecured. They’re just known as credit cards.
There are secured credit cards specifically designed for people who are working to rebuild their credit. If a credit card doesn’t say that it’s secured, then you can assume it’s unsecured.
- Amount: A credit limit is set based on your credit score; a higher score means a higher limit. You make charges to this line as needed.
- Interest rate: Rates on credit cards are typically fixed at the time you open the account. Credit cards have significantly high interest rates compared to other types of credit
- Payments: The monthly payments are revolving, meaning you pay a percentage of the balance you owe.
This refers to any type of loan that does not require collateral. This includes unsecured personal loans, as well as student loans. However, student loans are a specialized type of debt that don’t follow normal rules. For instance, you qualify for student loans based on need rather than your credit score.
- Amount: You receive the full amount you borrow as a single lump-sum.
- Interest rate: Rates on unsecured personal loans are typically fixed, but can vary widely based on your credit score
- Payments: You pay the amount you borrow back in installments (fixed monthly payments).
Banks and credit unions may also extend unsecured Lines of Credit (LOCs) to people with excellent credit scores.
- Amount: A consumer with strong credit may be able to qualify for a line up to $50,000; you borrow against the line as needed.
- Interest rate: Rates on LOCs are typically lower than rate on both credit cards and unsecured personal loans. In addition. you only pay interest on the amount you’ve borrowed.
- Payments: You pay a minimum monthly payment; it’s usually equal to the monthly interest charges. However, if you only pay interest charges, then you never pay the debt off.
The benefits and drawbacks
Pros of unsecured debt
The primary benefit of unsecured debt is in the name. It’s unsecured, so you’re not risking anything by assuming the debt (besides, perhaps, financial hardship). Still, there’s no property or cash deposit that you would be required to surrender upon default.
Another benefit is that unsecured debt usually rewards you for having excellent credit. A higher credit score will typically afford you:
- a higher credit limit
- lower interest rates
- in the case of credit cards, the best reward programs
Cons of unsecured debt
The biggest drawback of it is that, at least in most cases, secured debt offers lower interest rates that unsecured.
- a personal Line of Credit (LOC) will generally have a higher interest rate than a Home Equity Line of Credit (HELOC)
- unsecured personal loans have higher interest rates than mortgages or auto loans
There are exceptions to this rule. For example, secured credit cards tend to have higher interest rates than unsecured credit cards. Since these products are specifically designed for people with bad credit, they naturally have higher rates because the credit user is high-risk.
What’s more, while unsecured debt rewards consumers with excellent credit scores, it can be problematic for those with poor credit scores. If your score is low, you may not get approved for an unsecured credit line, while you might get approved for one that’s secured.
If you do get approved, you may face much higher interest rates and much lower credit limits. LOCs typically go up to $50,000 maximum limits, but that’s only extended to consumers with excellent credit. Meanwhile, rates on unsecured personal loans can go up to 45% APR if you have poor credit.
Managing unsecured debt
The biggest challenge with unsecured debt is how quickly it can become difficult to manage. This is especially true when it comes to revolving credit lines, such as credit cards and LOCs.
At first, these types of credit can seem harmless. You have minimum payments of $25 or $50. But as your balances go up, so do the minimum payment requirements.
If you have a series of emergencies or unexpected expenses that you can’t cover with savings, debt can increase quickly. Your minimum payment requirements increase right along with the balances, making it harder to budget and save.
The next unexpected expense goes on credit and the situation gets a little worse. It’s a vicious cycle.
However, there are some steps you can take to keep unsecured debt in check. There are also some specialized solutions you can use if it starts to become problematic.
Tips for managing unsecured debt in normal circumstances
Pay more than the minimum requirement
Never be satisfied with simply making the minimum payment requirement every month, particularly with credit cards and LOCs. If you only pay off interest charges, you’ll never eliminate any principal. This puts you at a higher risk of financial hardship.
For credit cards and LOCs, try to pay off as much of the debt as you can each month. The more of your balance you pay off, the less debt there is to apply interest charges to the next month.
Even with unsecured loans, making extra payments or larger payments will help you get out of debt faster. Just make sure to check if an unsecured loan has any early repayment or prepayment penalties.
Paid in full is ideal for revolving credit lines
Ideally, you want to maintain a zero balance on any revolving credit line. This is beneficial for two reasons:
- You avoid extra monthly bills and balances that drain your income.
- It’s better for your credit score.
Carrying high balances on revolving credit lines is bad for your credit. It negatively impacts your credit utilization ratio, which measures how much debt you have versus your total available credit limit. Anything higher than 30 percent will damage your score.
Check in periodically to see if you’re eligible for lower APR
This applies specifically to credit cards. Credit card companies will sometimes offer lower promotional rates to existing customers. This can help the APR applied to your purchases temporarily.
However, the companies may not reach out to you to offer the lower rate. In many cases, you need to call and ask if there’s any available offer to lower the rate applied to your balance.
You may also be able to request that the creditor lower your interest rate permanently. If you’ve been a good customer for a number of years who always pays your bills on time, the creditor may be willing to lower the APR on the account permanently.
Again, you never know until you ask! You don’t lose anything by contacting your creditors to see if you can get a better deal.
Juggling multiple revolving balances is risky
Juggling multiple revolving unsecured debt payments each month risks financial hardship. It also means that you’re wasting a lot of your hard-earned cash covering interest charges each month.
If you see this happening, you need to implement a debt reduction plan immediately. Balance your budget so you can stop making new charges on credit cards or withdrawals on a LOC. Then focus on paying down one balance at a time until you’re back to zero balances.
If your debt reduction strategy is not working, then you need to consider more aggressive measures like the ones outlined below.
Solutions for unsecured debt
While unsecured debt presents some unique challenges, there are also specialized pathways that you can use to overcome those challenges.
Unsecured debt can be consolidated, meaning you can take out a new unsecured debt to pay off existing ones. Debt consolidation loans, LOCs and even balance transfer credit cards can be used to pay off existing accounts.
The goal is to lower the interest rate applied to your balance, so it’s easier to pay off faster. It also helps if you’re in a situation where you’re juggling multiple bills.
You can also include unsecured debt in a debt management program through a credit counselling organization. The organization works with you and your creditors to set up a repayment plan that you can afford. It minimizes interest or even eliminates the APR applied to your balances so they’re easier to pay off.
Credit counselling can be effective when you don’t have success with consolidation, but still want to repay everything you owe.
If you are concerned that you’re headed for bankruptcy, a consumer proposal may help protect your assets. You arrange a settlement plan through a Licensed Insolvency Trustee. They determine how much of your unsecured debt you can reasonably be expected to pay back. Then you make monthly payments to the trustee that they disburse to your creditors.
Consumer proposals can be expensive but it can be worth it to save assets, such as your home and car. This type of solution only works for unsecured debts.