An unsecured creditor has no collateral against a loan. (Photo: iStock)
Remember that time back in elementary school when you loaned that kid 50 cents at the book fair so he could buy a funny eraser? He promised to pay it back and probably promised to be your best friend. But he didn’t, did he? Did you know that transaction made you an unsecured creditor?
A creditor is any person or entity that loans you, or your business, money or services for which you have not yet paid. Everyday examples include cell phone providers, mortgage lenders, utility companies and even health clubs.
There are two types of creditor: secured and unsecured. A secured creditor has possession of some sort of security or collateral. Security can take many forms and might include a deposit, the ownership of a vehicle or a lien on your home. An unsecured creditor, however, has no collateral against the loan. Credit card companies are probably the most familiar examples of unsecured creditors.
Higher risk for higher profits
It is reasonably evident that an unsecured loan is far riskier for the creditor than a secured loan. So, why would anyone offer such a loan? The same reason every business exists: to make money.
Unsecured loans tend to be modest in size, making them relatively low-risk for the creditor. The flipside of the coin is that they typically have far higher interest rates than secured loans do, setting up the potential for wide profit margins when payment is made.
What happens if I don’t pay an unsecured loan?
An unsecured creditor typically has little recourse if a borrower does not pay back the loan or pay for the service. A service provider can cut off the service, of course, but unpaid debts are a different matter.
The creditor could choose to launch a lawsuit against the debtor but the dollar amount would need to be significant to warrant the legal fees. Additionally, if the loan was not paid because the company or individual went broke, there may not be any assets with which to make payment. If the debtor declared bankruptcy, secured debts take first priority and there may be nothing left for unsecured creditors to claim.
What if I am the unsecured creditor?
If you gave your money to a business in expectation of a service or product, but that business does not uphold the deal, you are not only annoyed, you’re also an unsecured creditor. This happens more often than one might imagine.
In April 2017, a partnership formed to put on a large music festival in Pemberton, British Columbia. Although the event sold well, the festival had lost money several years in a row. Ultimately, the partnership declared bankruptcy and cancelled the multi-day event.
There was no automatic refund policy in effect, leaving ticket holders with nothing to show for their purchases except apologies from the organizers. Approximately 120 corporate lenders also lost their investments. The only option provided was to file a claim with the partnership’s accounting firm in hopes there might be some remuneration.
Pay it forward, and pay it back
Although the chances of an unsecured creditor successful recouping his/her/its losses from you are low, that doesn’t mean you shouldn’t make every effort to make a payment. Failure to pay can wreak havoc with your credit rating and may have unforeseen financial ramifications in the future. Looking at the big picture, it’s also not good for the economy.
Think about that kid who owes you two quarters to this very day. Still annoying, isn’t it?