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Unsecured Personal Loans: What Happens if You Don't Pay Them Back?

| Money Rates Columnist.
min read

empty-walletA personal loan is called "unsecured" because it's not tied to a particular asset that a lender is automatically entitled to repossess. But that doesn't mean you get extra leeway with your payments. So what happens if you don't pay an unsecured personal loan? And what can you do to prevent default?

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Unsecured vs Secured Loans

Unsecured loans are exactly that - loans unsecured by assets other than your good word. Secured loans require you to pledge assets that the lender can take if you don't repay as agreed. Mortgages (including second mortgages, such as home equity loans) and auto loans are the most common forms of secured borrowing.

And they both have one thing in common. If you default on one of these loans the lender has the right to turn up and repossess the pledged assets.

The repo person might turn up to take back your car. And a foreclosure process, which varies from state to state, could ultimately see you lose your home. Secured loan agreements name an asset (that vehicle or house) as "collateral," which means it serves as security for a loan. And the agreement gives the lender the right to seize collateral if you default.

But unsecured borrowing is different. No particular asset is named in the loan agreement, and no automatic right to seize any of your goods exists. Instead, the lender relies on your promise to repay the loan, coupled with your reputation as a responsible money manager.

Of course, the lender's probably never even met you. So what it actually relies on is your credit report and score.

Unsecured Borrowing: Credit Cards and Personal Loans

The credit card is probably the most common type of unsecured borrowing. And the personal loan the second most popular.

Of course, they're very different in many respects. To start with, plastic is "revolving credit" (you borrow, repay and borrow again up to your credit limit) while a personal loan is an installment loan, with fixed monthly payments and a fixed end date. And a personal loan is likely to come with a much lower interest rate, about 7% lower than a typical rewards credit card. So, if you want to borrow a particular amount for a set period, a personal loan is almost always better.

But, while they're very different in some ways, they're similar in a couple:

  1. Lenders of both rely heavily on your creditworthiness when deciding whether to approve your application - and what interest rate to offer you
  2. Neither names an asset or gives lenders an automatic right to seize it - so they're unsecured

So, if lenders can't seize an asset, how can it make you pay back the loan?

Personal Loan Default: What's the Worst That Can't Happen?

Let's start with the good news. No one is going to show up out of the blue and put a foreclosure notice on your door. Or take your car in the early morning hours.

You won't be surprised by collection efforts. Your lender will likely start by sending you a notice, a text or an email. And collection won't escalate unless you ignore your lender's attempts to make contact over an unpaid bill.

Delinquency vs Default

But, just because those extreme options are closed off to unsecured lenders, that doesn't mean they won't come after you hard if you fall behind with payments. The lender will probably report your missed or late payments to major credit bureaus. Your FICO score will take an immediate and profound hit as soon as that happens. And it will get worse with each month until you catch up.

Expect calls, letters and emails reminding you that you're late right away. And they may become more frequent and less polite as time goes by.

It's up to each individual lender to decide how long to wait before determining that you are "in default." Some might declare a loan to be in default just one day after the first late payment is due. Most are more generous, defaulting you once your payment is overdue by 30, 90 or 180 days.

And that's important. Because having a default on your credit report will wreck your credit score. And that's going to make borrowing in the near future very expensive - or even impossible.

Personal Loan Default: Worst Case

But that's just the beginning of the pain. Your lender's likely to escalate the pressure through its own in-house debt collection department or by using a collection agency. Sometimes it will sell the debt to an investor, who then attempts to collect from you. And some of those companies use very aggressive tactics to collect - don't plan on sleeping well if this happens.

Worse, your lender or collector will probably sue if you continue to stonewall. And that creates a public record for all to see, including credit bureaus and potential employers. Many borrowers have given up by then and don't bother turning up. Failing to appear in court creates even more serious consequences.

A judgment against you would be automatic in most jurisdictions. Your accounts could then be attached, your wages garnished and your home liened. Garnishment means your employer will be ordered by a judge to deduct a certain amount from each of your paychecks and send it to your lender until the debt (plus by now a host of late payment fees and legal and collection costs) has been settled. Attachment of accounts means your money will no longer be yours. And a real estate lien forces you to repay the lender (plus fees and interest) from the proceeds if you sell the home.

So it's worth suffering the indignity of a court appearance, just to discourage the judge from imposing garnishment payments that you can't afford. Because the lender's side will be there. And its attorney will be pushing for painfully high payments.

Avoiding the Pain

You can often head off all that unpleasantness at the pass. Just keep in touch with your lender and be pleasant, reasonable and candid with its agents.

Chances are, the person you speak to will have heard countless stories of hardship before. So don't be embarrassed when you tell yours. He or she is unlikely to be judging you.

But that person can't help you without having a full picture of your circumstances. You need to persuade the agent that you:

  • Have a genuine problem (sickness, period of unemployment, cut in working hours, unexpected obligation ...) and aren't just skipping payments to sustain your lifestyle
  • Wish to repay your debt
  • Can realistically do that with a little help
  • Have a firm grasp of your financial circumstances that you're willing to share without being evasive or untruthful

So, before you call, write down your income (or your expected income when you're fully back in work) and your expenses. Offer to send supporting documents, such as bank statements or a pink slip, that prove you're telling the truth.

Potential Assistance

If you can persuade the agent that you'll get back on track with a little help, you're a long way toward your goal. The help you might be offered may take one or more of these forms:

  1. Loan modification

    If you still have some income, you may be able to pay part of each installment as it falls due. The agent may be able to agree to those part payments for a limited period until you're back on your feet. But be aware, you'll have to catch up one day. And you'll still rack up interest on the unpaid balance.

  2. Term modification

    This is a bit like a loan modification. But you're asking for the loan to be made longer. So instead of making payments over, say, two more years, you make them over three, four or five. So you're spreading your payments more thinly and each installment should be smaller.

  3. Payment plan

    Once you are in a position to make up missed payments, you may agree to a higher monthly payment for a fixed period that lets you do so over several months.

  4. Forbearance

    This is what you need when you're in deep trouble. It means your lender gives you an agreed period in which you don't have to make any payments. But, you have to catch up eventually, and interest on the unpaid balance continues to accrue during your forbearance.

Remember: no lender is obligated to offer you any of these. So use all your powers of persuasion and have a credible, realistic plan - based on actual figures from your household accounts - for how you can ultimately repay your debt, given time.

The Hardest Part

The hardest part of this process is plucking up the courage to make the first call to your lender(s). After, you may well think it the best move you've made in a very long time.

Even if we bury them deep, financial worries are exceptionally stressful. And, if the call goes (or the calls go) well, you may be surprised by the weight that's lifted off your shoulders.

It's best if you call as soon as possible. But it's never too late. So just call. After all, what do you have to lose?

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