What Is Unsecured?
Let me explain what unsecured means in simple terms. Unsecured refers to a debt or obligation that isn't backed by any collateral. Collateral is property or other valuable assets that a borrower offers to secure a loan, which you see in secured debt. With an unsecured loan, the lender provides funds based on other factors about you, the borrower. These include your credit history, income, work status, and any existing debts.
Key Takeaways
- Unsecured is when a debt is not backed by collateral, making it relatively riskier than secured debts.
- In the event of default, these obligations must be repaid in other ways than seizing collateral.
- Because they are riskier, unsecured loans will carry higher interest rates than secured loans.
- Many personal loans, lines of credit, credit cards, and some business loans or bonds are unsecured.
Understanding Unsecured
You need to know that unsecured loans present a high risk to lenders. Since there's no collateral to claim if you default on the loan, the lender has nothing of value to take and cover their costs. Default occurs when you, as the debtor, can't meet your legal obligations to pay the debt. Instead of taking collateral, the lender turns to civil actions, such as hiring a collection agency or filing a lawsuit to recover unpaid balances.
Unsecured loans and lines of credit—also called flex loans—often come with high interest rates. These rates protect lenders against potential losses. The most common types are credit cards and personal loans.
Fast Fact
Here's a quick note: Unsecured loans or lines of credit are loans where lending happens without the backing of equal value collateral.
Unsecured vs. Secured Loans
Many of you are already familiar with secured loans, like mortgages and auto loans. In those cases, if you default, the lender can seize the collateral. For mortgages, this is called foreclosure. Once you miss a payment, the default process starts, and the servicer completes the legal steps to reclaim the property.
For auto, boat, or other large equipment loans, it's repossession. In both foreclosure and repossession, you lose the item securing the loan.
Secured loans have limits based on the collateral's value. For a home mortgage, you might only get a portion of the property's fair market value. The same applies to auto and boat loans.
Example: Problems With Foreclosures
Consider the 2006 housing market crash as an example. Foreclosed properties flooded the market, driving down the value of all houses. Before the crash, home values rose exponentially, creating a bubble. When it burst, the problem was twofold.
First, the surplus of houses led to lower overall home values. Like any product, more supply than demand forces prices down. This drop caused the second issue: homeowners saw their investment's worth fall and tried to sell, but with so much supply, it was often difficult or impossible. They began defaulting on mortgages.
Banks reclaimed these properties but couldn't sell them either. Some banks failed as a result, showing how even secured loans can be risky. Lending terms have changed dramatically since then, and banks are now more conservative.
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