Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Unsecured Loan

What it is:

An unsecured loan is debt that does not have any collateral attached.

How it works (Example):

Let’s assume you would like to borrow $100,000 to start a business. Even if you have an excellent credit rating, a bank may be reluctant to lend you the money because it may be left with nothing if you default on the loan. Thus, although banks may attempt the lengthy and expensive process of suing you in that circumstance, the bank may require $100,000 of collateral -- security -- in order to lend you the money. This collateral might consist of financial instruments, houses, cash, or even objects such as art, jewelry or other items. You might also pledge your business receivables as well. When you pledge these assets, you are collateralizing the loan.    

If you in fact default on the loan, the loan agreement gives the lender the right to seize, then sell the collateral in order to recover any outstanding balance.

For individuals, credit cards are the most common example of unsecured loans. There is no collateral backing up your Visa bill that Visa can seize if you don't pay your bill.

Why it Matters:

If a lender has claim to some of your assets -- say, a deposit you made, a lien on your house, the title to your car -- that creditor has a secured loan. If the creditor has no ability to claim some of your assets when you don’t pay (this is often the case with credit cards), the creditor has made an unsecured loan. If you have borrowed money from a bank, the bank may ask you for collateral as a way of securing the loan.

Unsecured loans are riskier than secured loans because the lender does not have the ability to seize an asset right away if a borrower fails to repay the debt. Creditors may of course sue to obtain access to accounts or other assets if the borrower has not paid, but that is more expensive than requiring collateral up front. Regardless, this lack of security increases the creditor’s risk, which in turn increases the interest rates on unsecured loans.