What Is Unsecured Debt?

The modern world revolves around credit. Being able to get what you want now and pay for it later not only helps consumers, it drives the earnings of corporations and entire economies. Most credit is not backed by any particular asset; it is given to the borrower on an agreement to repay according to certain terms.

Identification

Unsecured debt is any debt obligation that is not secured by a lien on specific collateral. A home mortgage is a secured debt because the lender can foreclose and possess the house if the mortgage is not paid. Unsecured debt, however, is not attached to a specific item of property. Credit card debt, though associated with specific purchases, is unsecured debt.

Function

Unsecured debt has different uses for the borrower and the lender. Those who borrow unsecured debt do not have to risk any specific assets by pledging them as collateral. The lender, not having collateral, takes on a greater risk with unsecured debt. As a result, lenders charge a higher interest rate--especially if the borrower has a poor credit rating--and potentially receive a greater total return.

Effects

The lender can lose all if a borrower defaults. The lender's only recourse in a default is to pursue a judgment against the borrower, possibly enforcing a wage garnishment if the borrower has a job. A lender can also force a defaulted borrower into bankruptcy proceedings. In bankruptcy, however, secured creditors have exclusive claim to collateral property. Under Chapter 7, unsecured creditors are paid only from the liquidation of the debtor's non-exempt property, and all remaining debt is absolved.

Features

The unsecured debt of the average individual is made up of lines of credit. Businesses, however, can have many sources of unsecured debt. Money raised by the issuance of stock is unsecured, meaning shareholders are a sort of unsecured creditor. The holders of debentures and unsecured bonds are also unsecured creditors.

Significance

The distinction between secured and unsecured debt is particularly important in corporate bankruptcy. Under Chapter 11, a debtor company can accept new super senior loans that go to the front of the line in terms of seniority. Accounts payable to suppliers and distributors, wages and salaries owed to employees, and secured bondholders are all repaid before unsecured creditors. At the end of the line are shareholders, whose claim is limited to any remaining or future equity in the company.