What is an Unsecured Loan?

What is an Unsecured Loan?

An unsecured loan is a loan that doesn’t require any type of collateral. Instead of relying on a borrower’s assets as security, lenders approve unsecured loans based on a borrower’s creditworthiness. Examples of unsecured loans include personal loans, student loans, and credit cards.

An unsecured loan is supported only by the borrower’s creditworthiness, rather than by any collateral, such as property or other assets. Unsecured loans are riskier than secured loans for lenders, so they require higher credit scores for approval.

If a borrower defaults on an unsecured loan, the lender may commission a collection agency to collect the debt or take the borrower to court. Lenders can decide whether or not to approve an unsecured loan based on a borrower’s creditworthiness, but laws protect borrowers from discriminatory lending practices.

Unsecured personal loans typically range from about $1,000 to $50,000. They’re typically repaid in fixed monthly payments over a set period of time, typically two to five years. They’re offered by banks, credit unions, and online lenders.

Common uses of unsecured personal loans:

  • Debt Consolidation
  • Credit Card Refinancing
  • Business Expenses
  • Home Improvements
  • Vehicle Purchases
  • Moving Expenses
  • Vacations
  • Medical Expenses
  • Wedding Expenses

How an Unsecured Loan Works?

Unsecured loans sometimes referred to as signature loans or personal loans are approved without the use of property or other assets as collateral. The terms of these loans, including approval and receipt, are most often contingent on a borrower’s credit score. Typically, borrowers must have high credit scores to be approved for unsecured loans.

An unsecured loan stands in contrast to a secured loan, in which a borrower pledges some type of asset as collateral for the loan. The pledged assets increase the lender’s “security” for providing the loan. Examples of secured loans include mortgages and car loans.

Because unsecured loans require higher credit scores than secured loans, in some instances lenders will allow loan applicants with insufficient credit to provide a cosigner. A cosigner takes on the legal obligation to fulfill a debt if the borrower defaults. This occurs when a borrower fails to repay the interest and principal payments of a loan or debt.

If a borrower defaults on a secured loan, the lender can repossess the collateral to recoup the losses. In contrast, if a borrower defaults on an unsecured loan, the lender cannot claim any property. But the lender can take other actions, such as commissioning a collection agency to collect the debt or taking the borrower to court. If the court rules in the lender’s favor, the borrower’s wages may be garnished.

Also, a lien can be placed on the borrower’s home (if they own one), or the borrower may be otherwise ordered to pay the debt. Defaults can have consequences for borrowers, such as lower credit scores.

An unsecured loan is a loan that doesn't require any type of collateral.

Pros and cons of Unsecure loans

Pros:

  • You don’t need to appraise or offer up an asset like your home or car.
  • Your application may be approved in minutes, and the funds may be deposited into your account as quickly as the same day or the following business day.
  • If you don’t finish repaying the loan, your property will not be repossessed.
  • Unsecured personal loans usually have fixed interest rates that don’t change for the life of the loan.

Cons:

  • Often require higher credit scores in order to qualify since there is no collateral to offset risk for lenders.
  • May come at higher interest rates than secured loans.
  • Approval process largely leans on borrowers’’ credit profiles such as score and history.
  • If you do not repay the loan, your credit score will be severely impacted, and your lender may send your debt to a collection agency.

How to qualify for a personal loan

Lenders may have different qualification requirements, and they all weigh those requirements differently, but there are some general factors that help you qualify for low rates.

  • Good credit. Good- and excellent-credit borrowers (above 689 FICO) typically get the lowest APR on a personal loan. Some lenders cater to fair- and poor-credit borrowers (300-689 FICO), but the best terms and rates are reserved for those with high credit scores.
  • Low debt-to-income ratio. Many lenders check if your debt-to-income ratio is low enough to support monthly repayments. Some say borrowers need a 40% DTI or lower to qualify, but others have higher limits.
  • Stable credit history. Lenders favor borrowers who can show that they’ve consistently made on-time payments across multiple accounts which can be credit cards, auto loans or other installment loans over a number of years. Aim for at least two or three years of credit history across two or three accounts.
  • Steady income. Having a steady income can signal to a lender that you’ll have the funds available to repay your loan.

Pre-qualifying for a personal loan with an online lender lets you see potential loan terms, including the loan’s interest rate, loan amount, and payments. You can then compare offers to find the loan that gives you an amount you need and a payment you can afford.

Applying for an unsecured loan

Once you’ve pre-qualified, the application process can vary by lender. Online lenders, bank lenders, and credit unions have different application processes.

  • Online applications: If you’re applying for a loan online, you can typically complete the entire process without having to make a phone call. In some cases, your loan can be funded the same or next business day.
  • Bank applications: Some banks have online applications, but many require an in-person visit to complete the process. Banks may also require you have an existing account before you apply.
  • Credit union applications: You usually need to be a member of a credit union to borrow money from it. Membership is often tied to where you live or work, or organizations you’re involved with, but some credit unions allow anyone to be a member.

Here’s what you usually need for an unsecured loan application:

  • Phone number.
  • Social Security number.
  • Employer information.
  • Education history.
  • Financial information, like retirement assets, home equity and bank account information.

Types of Unsecured Loans

Unsecured loans include personal loans, student loans, and most credit cards—all of which can be revolving or term loans.

A revolving loan is a loan that has a credit limit that can be spent, repaid, and spent again. Examples of revolving unsecured loans include credit cards and personal lines of credit.

A term loan, in contrast, is a loan that the borrower repays in equal installments until the loan is paid off at the end of its term. While these types of loans are often affiliated with secured loans, there are also unsecured term loans. A consolidation loan to pay off credit card debt or a signature loan from a bank would also be considered unsecured term loans.

In recent years, the unsecured loan market has experienced growth, powered partly by fintech’s (short for financial technology firms). The past decade, for example, has seen the rise of peer-to-peer (P2P) lending via online and mobile lenders.

If you’re looking to take out an unsecured loan to pay for personal expenses, a personal loan calculator is an excellent tool for determining what the monthly payment and total interest should be for the amount you’re hoping to borrow.

Unsecured Loan vs. Payday Loan

Alternative lenders, such as payday lenders or companies that offer merchant cash advances, do not offer secured loans in the traditional sense. Their loans are not secured by tangible collateral in the way that mortgages and car loans are. However, these lenders take other measures to secure repayment.

Payday lenders, for example, require that borrowers give them a postdated check or agree to an automatic withdrawal from their checking accounts to repay the loan. Many online merchant cash advance lenders require the borrower to pay a certain percentage of online sales through a payment processing service such as PayPal. These loans are considered unsecured even though they are partially secured.

Unsecured loan alternatives

You may want to consider alternatives along with a personal loan. There are a variety of personal loan alternatives, depending on what you’re financing.

  • 0% APR credit card: These cards work well if you need to finance a wedding, repay medical bills or consolidate debt. You need good or excellent credit to qualify and debt small enough to be repaid in the card’s 12- to 18-month, interest-free period.
  • Credit unions: Credit unions tend to offer lower interest rates to members with fair or poor credit (a score under 690) than banks or online lenders do. Federal credit unions cap their APRs at 18%.
  • Home equity loans and HELOCs: These are good options for home renovations if you’re comfortable using your home as collateral and have enough equity to qualify.

A home equity loan can give you a longer repayment term and typically a lower rate than a personal loan. A home equity line of credit lets you use funds as needed, and you only pay interest on what you use.