What is unsecured?
In business and finance, the term ‘unsecured’ refers to loans or debts that are not guaranteed by a specific asset of the borrower.
Put differently, the loan or debt is not backed by collateral.
The unavailability of collateral presents a high risk to a lender because if a borrower defaults on a loan there is no option available to recover the outstanding debt, except going to court and obtain a court order.
To mitigate the possible risks of loss, unsecured loans and debt have high-interest rates.
The term is used in different aspects of debt financing in the world of finance and business.
Unsecured credit
Unsecured credit can be obtained in the form of credit cards, personal loans, microloans, and retail stores accounts.
Unsecured credit is convenient and useful when a person is required to cover emergency expenses or wants to buy household items such as furniture, or electronic goods.
Credit cards are almost the easiest way to obtain debt from an unsecured creditor.
Basically, unsecured debt is granted based on a borrower’s:
- promise and commitment to pay back the debt on a regular basis,
- credit history, and
- payment behaviour.
Unsecured credit is also called unsecured debt or unsecured loans.
Unsecured creditors
An unsecured creditor is a lender (individual or financial institution, such as a bank) that lends money to a borrower without requiring specified assets as collateral.
If a borrower defaults on an unsecured loan, the unsecured creditor is not allowed to confiscate any of the assets of the borrower without securing a court order.
Usually, the bankruptcy of a borrower is the only remedy for an unsecured creditor if the borrower fails to repay his or her debt.
What is an unsecured note?
In finance, an unsecured note is a corporate debt obligation that has no collateral attached to it. In other words, it is a loan that is not secured by the assets of the issuer of the note.
It is primarily a legal document or agreement in finance in which the issuer (borrower) acknowledges the debt obligation and promises to pay the lender the principal amount, as well as interest payments, at an agreed predetermined date or periodic intervals agreed upon.
Similar to other types of debt, the terms of the notes may vary, as well as the interest rates, maturities, and face values.
Some other features of unsecured notes
Typically, unsecured notes also comprise the following features:
- Time frame
It is a medium-term type of debt with longevity of usually three to ten years, and with predetermined dates on which the interest associated with the debt is payable.
- Risk level
Unlike secured debt, unsecured notes are associated with high levels of risk. As mentioned, the notes are not secured by the assets of the issuers (borrowers), increasing the risk of collectability.
Hence, the principle of ‘the greater the risk, the higher the reward’ is applicable. Therefore, the return to be received on the debt by the lender is also relatively higher.
- Exchange of notes
In the corporate world, unsecured notes can be exchanged via private offerings (available to a small group of investors). This strategy enables corporations to generate capital for corporate ventures, such as the repurchase of shares, acquisitions, and mergers.
- Trading of unsecured notes
It is quite difficult to trade an unsecured note because of the very fact that it is unsecured. Unsecured notes are issued solely on the basis of the lender’s faith in the borrower, without the backing of collateral.
Other investors or lenders may not have the same trust in the borrower as the original lender, making it very difficult to trade the notes in comparison with, amongst others, promissory notes, or secured notes. (A promissory note refers to a written and signed promise by one party to another party to pay a certain amount of money at a specified date or on demand.)
Unsecured notes and debentures
Unsecured notes and debentures are two different types of debt instruments. (A debenture is a type of debt instrument that also has no collateral as backing.)
Superficially, unsecured notes and debentures appear to be the same type of debt, comprising the same features such as no assets attached as collateral, high-risk levels, and higher rates of return.
However, unlike unsecured notes, debentures have insurance policies that cover the risk of the lender or investor when the borrower defaults on his or her debt obligation.
Unsecured debt compared to secured debt
Contrary to unsecured debt, secured debt, also called collateralized debt, occurs when a borrower is required to pledge an asset (or more than one asset, if necessary) of which the value covers the amount of debt applied for.
Assets pledged as collateral can include property, such as a house, vehicles, securities, and other types of investments.
Examples of secured debt or secured loans are mortgages and vehicle loans, also referred to as auto loans. Mortgages and vehicle loans are examples of debt where the asset acquired also serves as collateral for the loan that makes the acquisition possible.
If a borrower defaults, the asset pledged as collateral can be sold to recoup the outstanding debt amount, minimising the risk of the lender. Although, a borrower can still owe money after the process of repossession when the money obtained from the sale of the asset does not cover the outstanding loan balance in full.
To obtain a secured loan, a prospective borrower has to go through a vetting process to determine whether he or she qualifies for a secured loan. The vetting process includes, inter alia, the following measures:
- Verifying the borrower’s creditworthiness.
- Assessment of the value of the asset that will serve as collateral.
- Confirmation of the employment status and the level of income of the prospective borrower.
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