What is 'Unsecured'
Unsecured loans or lines of credit are funds that are lent without being backed by collateral. The lender lends the money based on other qualifying factors, such as credit history, income and other existing debts.
BREAKING DOWN 'Unsecured'
Unsecured loans present the highest risk to lenders because there is no collateral to take as recourse if the borrower defaults on the loan. Instead they will need to turn to civil actions such as collections agencies and law suits to recoup any unpaid balances. These loans and lines of credit often have the highest interest rates as well to insulate lenders against loss. The most common forms of unsecured funds are credit cards and personal loans.
Differences between Unsecured and Secured
Many people are already familiar with secured loans in the form of mortgages and auto loans. In both of those cases the collateral which the loan has been secured against will be reclaimed in the event of default. For mortgages, this occurrence is called a foreclosure. Once a borrower has missed a payment the default process has begun. The servicer will complete the legal requirements on their end to reclaim the property that the mortgage has been secured against.
In the case of an auto loan, the occurrence is known as repossession. In both instances the borrower who has defaulted will lose the item that the loan has been secured against.
Secured loans are limited by the value of the collateral that they are securing against. When it comes to a mortgage, which is secured against a property, you can only borrow up to a certain percent of the fair market value of the home, but no higher. The same thing goes for an auto loan. You cannot borrow more than the automobile is worth.
In 2006, when the housing market crashed, and the market was flooded with homes that had been foreclosed on, values plummeted. This caused the bubble bursting problem to be two-fold. The surplus of homes led to lower values. Just like when there is more demand then supply, values increase, when there is more supply than demand, the values drop. This caused even more people to default on their homes when they were unable to sell. The banks reclaimed these properties and then found that they could not sell them either. Some of those banks went under as a result, which provided an example of how even secured loans can be risky business.
Lending terms have changed greatly since then, and banks are now more conservative as a result.