Unsecured debt includes credit card debt, student loans, personal loans, cash advances, medical debt, retail store accounts, and money borrowed from family or friends. This article will discuss unsecured debts, what happens if you default on these types of debts, and what options you have for dealing with them after defaulting.
For the great majority of Americans, if we exclude what we owe on our homes, most of the debt we owe is unsecured debt. Unsecured debt includes credit card debt, student loans, personal loans, cash advances, medical debt, retail store accounts, and money borrowed from family or friends. This article will discuss unsecured debts, what happens if you default on these types of debts, and what options you have for dealing with them after defaulting.
What is an Unsecured Loan?
Loans come in two varieties: secured loans and unsecured loans. A secured loan is a loan that is backed by assets or property as a guarantee of repayment. The asset or property with which you pledge to secure the loan is known as collateral. The most common type of secured loan is a mortgage since mortgages are secured by the home that was purchased with the mortgage proceeds. If you fail to repay your mortgage, the real estate you purchased with the mortgage loan can be repossessed by the lender as repayment. Another common type of secured loan is auto loans, which work the same way.
An unsecured loan is a loan that is not secured by other funds or property. In most instances, the only thing backing the loan is your pledge to pay it back. The most common type of unsecured loan is a credit card. Other than your agreement to repay the money you borrow on your credit card, most credit card issuers do not have a right to take the merchandise purchased with the credit card as repayment if you fail to make your payments. Some other types of unsecured loans include business loans, student loans, and even debt consolidation loans. A debt consolidation loan is a popular means of merging multiple debts owed on several unsecured accounts into one loan with one monthly loan payment. Student loans are also a type of unsecured loan, although they tend to have hallmarks more commonly associated with secured loans. When you take out a student loan you not only “agree” to repay the loan but you must also execute something known as a “promissory note.” The promissory note then becomes the collateral for your student loan similarly to the way a “check” secures your obligation to pay for items purchased with the check.
Because their loans are not secured by collateral, most unsecured creditors rely on reputation and good faith to trust that you will repay your unsecured debt. A record of how you honor your financial obligations is maintained by several major private corporations known as credit bureaus. These bureaus generate credit reports concerning the loans you take out, and your history of payments and/or default. This history is then reduced to an individual bureau’s assessment of your credit score. All three bureau scores are scaled against the credit scores of other responsible borrowers to rate your overall creditworthiness. As long as you make the payment required every month, your lender will report this positive information to the credit bureaus, giving other consumer credit lenders a favorable indicator of your creditworthiness. If you miss a payment or stop paying altogether, they will also report this information, partially to warn other lenders that you did not make the payments as required per the terms of your loan agreement. This, in turn, will cause your credit score to go down and may cause some or all of these lenders to refuse to lend you money in the future.
In addition to reporting your credit history to credit bureaus, some lenders will also insist that you agree to automatic monthly payment deductions made from your bank account as a condition of obtaining an unsecured loan. These automatic monthly deductions not only increase the likelihood that you will make your payment every month but also that the payment will be made on time. In addition, automatic monthly payment deductions can sometimes be very difficult to cancel, requiring you to contact both your lender and your bank to have the payments stopped.
What Happens if I Default on an Unsecured Loan?
Just because an unsecured loan is not secured does not mean there are no consequences if you fail to repay the debt or fail to make your payments on time. Most creditors assess hefty late payment fees each month that your payment is not received on time. In addition, if you have agreed to have your payments automatically deducted from your account and the funds to cover the payment are not available when your lender attempts to make the deduction, your bank account will most likely be overdrawn resulting in even more significant insufficient fund fees charged by your bank. Late fees and insufficient fund fees associated with business loans can even be much higher, as business loans are not usually covered under federal and state consumer protection laws.
Simply not making your payment on time is known as a delinquency and can be quite costly. If you stop paying your loan altogether for several months, you will be in default on that loan. Once your loan goes into default, it will most likely be turned over to a debt collector. The debt collector will then begin calling you numerous times per day requesting payment on the debt. These calls will typically be accompanied by threatening collection letters in the mail. If neither of these collection tactics works, the debt will most likely be turned over to a professional debt collection law firm representing either the debt collector or the original creditor.
While most law firms will make an initial attempt to settle or collect payment on the debt from you, they are not required to do so. Other than a letter simply stating that they have taken over the debt and providing you with information where you can submit your payments, the only other correspondence you may receive from them is notification of a lawsuit requiring you to appear in court. Once the lawsuit has been filed, your lender will be a lot less likely to settle the account or offer you reasonable repayment terms. This is because if the creditor wins the lawsuit, a judgment will be issued against you. A judgment is a court order declaring that you owe the debt and that it must be repaid. The unsecured debt then essentially becomes secured by the judgment of the court.
In addition to the numerous means of enforcing a judgment at the creditor’s disposal such as garnishments and bank account levies, the creditor may also report the judgment to the credit bureaus, which will significantly lower your credit score. The judgment can remain on your credit report for up to 10 years, whether you ultimately pay it or not, in addition to the other negative information on your credit report which can remain on your credit history for up to 7 years. All of which will impact your ability to obtain credit in the future and lead to significantly higher interest rates on any credit you do eventually obtain.
What Are My Options After the Default?
Because there are real consequences associated with failure to pay unsecured debt, simply ignoring it after defaulting is never an option. There are things you can do to address the loan default and either keep it from getting worse. You may even be able to legally free yourself of the obligation to repay it for good.
The first thing you should try and do when you have defaulted on the terms of an unsecured loan is to contact the lender directly. Explain your situation to the lender and let them know you want to repay the debt but you need their help to do so. Many lenders will waive one or more loan payments, lower the required monthly payment, waive late or over-the-limit fees, or temporarily lower interest rates.
If you are unable to work out an acceptable agreement with your lender directly, contact a non-profit credit counseling agency. These licensed credit counseling agencies can work with you to construct a debt management plan that will combine all your monthly unsecured debt payments into one easy monthly payment, often with a lower interest rate and waived over-the-limit or late payment fees. If you choose to get help negotiating with your creditors, be sure you are dealing with a licensed credit counseling agency and not a private debt settlement firm. Debt settlement firms try to settle your unpaid debts with your creditors for less than you owe. Debt settlement firms are for-profit companies and can charge significant fees for every loan they settle for you. Moreover, many are scams. If debt settlement is an option that intrigues you, make sure to research the debt settlement process before you commit to this form of debt relief.
Using a New Loan to Pay It Off
Another means of dealing with unsecured debt that has gone into default involves taking out a new unsecured debt consolidation loan to pay off your existing high-interest accounts. This type of loan can take the form of an unsecured personal loan, home equity loan, home equity line of credit, or credit card balance transfer. Home equity loans and home equity lines of credit can be extremely risky, however, as the unsecured loan is now secured by the equity in your home and you can put your home ownership at risk if you default again. However, the benefits of a debt consolidation loan are often significant enough to outweigh most risks. For example, a debt consolidation loan may combine one or more delinquent unsecured loans into one, new, non-delinquent unsecured loan with a single monthly loan payment and a lower rate of interest than the loans you’re paying off separately. Be aware that getting another unsecured loan will usually require a credit check and if you have already missed payments with another lender, getting approved can be very difficult. You will likely only be able to secure a debt consolidation loan while you still have good credit. By contrast, debt management plans do not require you to have excellent credit. If a debt consolidation loan isn’t a good option for you, a DMP might be.
Getting Relief Through Bankruptcy
In most instances, if you have to borrow money to make the payments on loans you already have, that is a sign of more significant financial problems that may need to be addressed through bankruptcy. Bankruptcy not only addresses the delinquency on your unsecured debt, it eliminates eligible debts outright. When you file bankruptcy, most or all of your unsecured debt will be discharged at the conclusion of your bankruptcy, relieving you of the obligation to repay that debt. Some exceptions to this rule do exist for recently opened lines of credit and purchases made within one year of the filing of your bankruptcy petition.
Bankruptcy also immediately puts an end to harassing phone calls and other collection actions from law firms and collection agencies. While it is true that your credit rating will take an initial hit when you file bankruptcy, this temporary dip in your score likely won’t mean much practically if most of your debt is already in default. In fact, many creditors look more favorably on consumers following a bankruptcy than they did prior to the bankruptcy because the consumer has taken proactive steps to resolve their financial problems. As a result, you can often rebuild your credit and raise your credit rating shortly after having filed bankruptcy through timely payment of a car loan and/or secured credit cards. Some people have described bankruptcy as financial open-heart surgery. The surgery saves your life but you still need to go on the low-fat diet afterward to deal with the underlying condition that threatened your life in the first place to fully take advantage of your fresh start.
There are consequences to not paying your unsecured debt. However, there are also options available to help you successfully manage it. Ultimately, the first step to dealing with your unpaid unsecured debt is to simply not ignore your overdue financial obligations. In the event that filing for bankruptcy is the best option available to you, Upsolve can help.