The term 'Unsecured Debt' is included in the Corporate Finance edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...
Unsecured debt refers to a kind of loan that does not have any underlying asset which is backing it. This means that if the borrower defaults, the lender has no valuable property to seize against the loan’s repayment. Such debt has a wide range of examples. These include credit card bills, utility bills, medical bills, and other forms of credit or loans which a financial institution offered without requiring any backing collateral.
These debts are extremely risky for lending institutions. The creditors will be forced to sue in an effort to collect their principal should the borrowers choose to not pay back the full amount of their obligations. It is not only personal bills which can be unsecured. Unsecured debt also includes business debts. Because the risk of default is considerable for the lenders, they usually charge higher rates of interest. This is a proverbial double edged sword. Since the higher rates make the financial burden heavier for the borrower, it can literally push them into default in an ironic self-fulfilling prophecy.
Borrowers have the ability to eliminate their unsecured debt. They can do this in the bankruptcy courts of the United States. The results will be that their debts are either discharged or restructured (in the case of businesses especially). Such an action will have consequences for the borrowers. They will find it harder to get unsecured loans in the future.
There are some important differences between unsecured debt and secured debt. Debt which is secured is backed up using a valuable asset. This could include the vehicle for which the loan is made, or the real estate for which it is provided. The official name for this is collateral. The legal terms in secured loans permit the lender to simply seize its underlying collateral which guarantees the loan if and when the borrower defaults on the payments. Secured debts cover a range of loans. These include title loans that vehicles secure and real estate or home loans that the property secures.
Naturally borrowers have far more to lose personally when they default on such secured loans than on any unsecured debts. This is because the loss of the borrower proves to be the gain of the lender in the respect of the collateral. Since this kind of debt turns out to be significantly less risky on the part of these lenders, they are happy to provide a more competitive interest rate, especially as measured against the rates on unsecured debt.
When a person does not make good on their pledge to repay on an unsecured debt, creditors will go through a number of steps. They first contact the borrower in an effort to recover payment. In the event that the creditor and borrower are unable to come to agreement on a revised repayment schedule, then the creditor moves on to the next steps in the process.
They will do one of several things. They might report the delinquent borrower to one of the big three credit reporting bureaus. They could also sell the delinquent debt on to a debt collection agency which will aggressively pursue debt collection. Finally, depending on the state in which the borrower resides, the creditor could choose to file a lawsuit in an effort to force repayment of the debt.
There are states such as Florida which do not allow legally forced collections of debt. These places protect the consumers from aggressive debt collection methods such as court ordered debt restitution. In other states, when creditors file debt collection law suits in the federal or state courts, the courts can decide to force the borrowers to pay back their unsecured debts utilizing certain available resources or assets.
Corporations also receive loans which are unsecured debt. When such debt issues are being rated by the bond ratings agencies, they will typically provide that issue with a lower rating. One example surrounds the Meta Financial Group which issued unsecured debt in 2016. The KBRA Kroll Bond Rating Agency determined that this senior unsecured debt deserved an only BBB+ bond rating because it was unsecured. This is relatively low, since junk bond ratings are BB. Highest ratings from this company were AAA ratings.
Meta Financial was fortunate to receive the BBB rating though there was no underlying asset backing the debt. This was due to the company’s strong quality of assets, healthy liquidity profile, and positive capital ratios on a risk-weighted basis. Had the issue been instead secured debt, then the bond rating agency likely would have delivered an A or better rating.