What You Need to Know About Unsecured Debt

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Debt isn’t one-dimensional. In fact, it comes in many forms, depending on what you owe, who you’re borrowing from and what can happen if you don’t pay on time.

Unsecured debt — debt that isn’t backed by an underlying asset — is one of those forms. Basically, it’s a debt without collateral, meaning there’s no property — a car or a house, for example — for your lender to take away if you don’t make your payments.

There are upsides and downsides to this, and understanding both can help you prioritize your finances and pay back what you owe.

Here’s everything you need to know about unsecured debt.

Which kinds of debt are considered unsecured?

Unsecured debt includes money you have borrowed with no collateral, meaning your lender will ask for more money — typically in the form of interest and late fees — if you don’t pay on time. If that doesn’t work, they’ll send debt collectors after you and could sue you for the amount you owe. These are some of the most common types:

  • Credit card debt
  • Personal loans
  • Student loans

Many of these debts are extremely common. For example, a March 2019 study by ValuePenguin found that the average U.S. household owes $5,700 in credit card debt. The average American also owes nearly $33,000 in student loans, according to a May 2017 report from the Federal Reserve.

What’s the difference between secured and unsecured debt?

Secured debt involves any loan where you have to put something down as collateral — and if you default on your payments, the lender has the right to the right to take that collateral away. Here are a few examples:

  • Mortgages: Here, the underlying asset is the house you’re making payments on.
  • Car loans: Usually, the lender can seize your car if you default on your loan.
  • Secured credit cards: Some credit cards are secured by a deposit you pay up front.

Amanda Zoch McGrath, CFP, a senior wealth advisor with Asset Advisory Group in Kinnelon, N.J., said secured debts typically have less expensive rates than unsecured debts. The reason for this is simple: Unsecured debts are considered riskier for lenders.

“[It’s] usually a higher risk loan for the lender, so it’s typically more expensive for the borrower,” said McGrath. “[I]f the borrower defaulted or didn’t repay the loan, the lender would have to sue them to get their money back,” though she noted that this was just one option for lenders if a payment agreement could not be made.

McGrath added that unsecured loans may also come with stricter conditions. For example, lenders might ask you to meet a minimum net worth requirement, or prove you have a recurring source of cash flow.

Which one should you pay off first?

According to McGrath, if you only have enough money to tackle one type of payment, you would ideally focus on paying off your unsecured loans, as they tend to have higher interest rates. This strategy could save you money on interest in the long run.

“Typically, since unsecured debt is more expensive, if you can afford to make debt payments, it really makes sense that you pay off the highest rate first, which would be unsecured [debts],” she said. “Those generally have higher rates, and they can get out of control quicker.”

However, McGrath acknowledged that there are instances where it may be more important to take care of your secured loans first, especially if the secured item could be integral in preserving your ability to pay your debts.

“Let’s say you have a car loan, and you really can’t afford [this payment] and you're at risk of losing your car,” she posited. “Maybe in that situation it might make sense to pay off [this debt] so you don't lose your car, which could prevent you from getting to work or earning money for your job.”

Do you have to pay back unsecured debt?

Zero collateral does not mean zero consequences. Just because you can’t lose property from an unsecured debt, that doesn’t mean you should ignore the payments.

If you’re late paying your credit card bill, you’ll usually be subject to late fees and possibly an interest rate hike. What’s more, a late payment will typically show up on your credit report 30 days after the due date, and once it does that, it stays there for seven years.

Late payments are especially significant, because they make up a huge part of credit score calculations. “It’s one of the biggest drivers of calculating your score,” according to McGrath, “so even just one late payment could really hurt your score.”

In fact, payment history is the biggest factor in determining your FICO credit score, comprising 35 percent of the calculation, and, as McGrath noted, the higher your score, the more liable it is to suffer from a late payment. According to FICO data, an individual with a 780 FICO Score could see their score drop as many as 110 points as a result of a 30-day delinquent payment.

A bad score could make it harder to get future loans, as well as apartments, jobs and some forms of insurance, so it’s worth avoiding late payments when you can.

How to get rid of unsecured debt

There are plenty of methods for tackling unsecured debts, but here are a few simple strategies:

  • Create a detailed budget: McGrath said this should be your first step, as it will help you understand each of your expenses and how much cash you can put toward your debts. There are plenty of free budget apps for this, including Mint, which McGrath said she uses herself.
  • Categorize your debts: Place your debts in order of interest rate, with the highest rate at the top of the list. This debt should be your first priority.
  • Consolidate your payments: Debt consolidation is the process of combining multiple debts into one single debt. This will make keeping track of your bills much easier, and help you repay them with less stress. Usually, you’ll want to get a consolidation loan or a balance transfer card with a generous 0% interest period. Here are some of the best consolidation loans available right now.
  • Use extra cash wisely: Whenever you get a work bonus or unexpected payday, McGrath suggests thinking critically about how you celebrate. Instead of splurging on a vacation or shopping spree, she recommends putting some or all of that money toward your debts.

No one wants to think about debt, but knowing the details of what you owe is the first step to paying it back. Whether you have unsecured debts, secured debts or both, understanding the facts can help you seize control of your finances moving forward.

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