Unsecured loans are borrowing products offered by banks, credit unions, and online lenders that are not backed by collateral. They include student loans, personal loans, and revolving credits such as credit cards. You will generally need good or excellent credit and a stable source of income to qualify for the best loan terms, and you are free to use the loan proceeds as you see fit in most cases .
What is an unsecured loan?
Unsecured loans are loans that do not require collateral. They are also called signature loans because a signature is all that is needed if you meet the lender’s borrowing requirements. Since lenders take on more risk when loans are not secured by collateral, they may charge higher interest rates and demand good or excellent credit.
If a borrower stops making payments and defaults on the unsecured loan, the lender has no collateral to take to collect the outstanding debt.
For example, suppose a borrower becomes unemployed and cannot repay his unsecured personal loan and unsecured credit card debt. When loan accounts are in default, the borrower’s credit will be affected. In this situation, the lenders might decide to bear the financial loss. They can also seek repayment of the debt through a court order, but they cannot seize a debtor’s assets without going through the court process.
Types of Unsecured Loans
There are several types of unsecured loans to choose from. However, the most popular options are personal loans, student loans, and credit cards.
As the name suggests, student loans are designed to help offset the costs of higher education. Credit cards can be used to make everyday purchases or cover unexpected expenses until you get back on track financially.
Personal loans generally do not come with restrictions on how the funds can be used. Thus, you can borrow funds if you face an emergency or to meet urgent financial goals. Some lenders also market these debt products as home improvement loans, wedding loans, or debt consolidation goals, but they work the same way as traditional personal loans.
Benefits of Unsecured Loans
- No collateral required
- Quick access to funds
- No risk of losing assets
- Fewer borrowing restrictions
- Competitive rates for those with strong credit
Disadvantages of unsecured loans
- Risk of loss of assets
- Could have lower borrowing limits for those with low credit scores
- Could have higher interest rates for those with low credit scores
- Harder to get approved
Unsecured Loans vs Secured Loans
Secured loans differ from unsecured loans in that secured loans always require collateral. If a borrower does not agree to provide an asset as insurance, the lender will not approve a secured loan.
This type of loan exists for a variety of financing options, including mortgages, auto loans, home equity lines of credit, and some types of personal loans. Borrowers are unlikely to encounter unsecured mortgages or auto loans, as the home or vehicle is still used as collateral for these types of loans.
Getting approved for a secured loan can be easier than getting an unsecured loan because secured loans pose less financial risk to lenders. Since they require collateral, they generally have more competitive interest rates than unsecured loans.
How do unsecured loans work?
Unsecured loans can be either unsecured installment loans, such as unsecured personal loans, or unsecured revolving lines of credit, such as unsecured credit cards. When you submit an application, the lender will check your creditworthiness and consider factors such as your income, savings, and debts to determine if you qualify.
Although unsecured loans and lines of credit are only secured by your promise to pay, the lender still has recourse if you don’t make the payments. The lender can send your account to a collection agency, sue you to garnish your wages, and report your late payments to the credit bureaus. These actions will cause your credit scores to drop
Who should get an unsecured loan?
Whether an unsecured loan is the right option depends on the financial situation of the borrower and the purpose of the funds. Borrowers who need money but are not comfortable giving collateral to secure a loan may consider an unsecured loan when:
- Planning a major purchase. Getting into debt can put a strain on your finances, but if you need funds for a big expense coming up, an unsecured loan can help.
- They have good credit. Having a high credit rating unlocks unsecured loan terms and more favorable interest rates.
- They have reliable incomes. Although no collateral is needed for an unsecured loan, you will need a steady income to pay off the debt and avoid defaulting on the loan. Unpaid secured loans can negatively affect your credit.
- Debt consolidation. Unsecured loans are useful as debt consolidation tools that can simplify debt repayment. This strategy can also help borrowers save money if they qualify for lower interest rates.
Qualifications for an unsecured loan
To limit their risk, lenders want to be reasonably sure that you will be able to repay the loan. Lenders measure this risk by checking a few factors, so they may ask for the following information when you apply for an unsecured loan (and tailor loan terms based on your answers):
Lenders check your credit reports to see how you’ve handled loans and credit cards in the past. Typically, they look for a history of responsible credit use (usually a year or more), on-time payments, low credit card balances, and a mix of account types. They will also check your credit scores, which are calculated based on information in your credit reports. Consumers with credit scores around 700 or higher generally qualify for the best interest rates.
Knowing that you have the means to meet your financial obligations, including loan repayments, reduces lender risk. The lender may ask to see proof of stable and sufficient income, such as a current pay stub.
Your debt to income ratio
To calculate your debt-to-income ratio (DTI), add up all your monthly debt payments and divide that total by your gross monthly income. For example, if you have $500 in existing debt repayments and $2,000 in gross income each month, your DTI is $500 / $2,000 = 0.25 or 25%.
Lenders use this number to measure your ability to repay a loan. The lower the ratio, the better. Each lender will have a different requirement for your DTI, but the maximum is generally no higher than 43%.
Although unsecured loans do not require collateral, the lender may want to know that you have savings. They know you’re less likely to miss loan payments when you’re ready for financial emergencies.
How to apply for an unsecured loan
If an unsecured loan is right for you, the application is done in several simple steps:
- Determine how much you need. Borrow only what you need, even if the lender approves you for a higher amount.
- Research the best lenders. You can find unsecured loans from state and local banks, credit unions, and online lenders.
- Compare unsecured loan offers. Some lenders offer prequalification so you can see what loans you might qualify for before you apply. Review interest rates, fees, loan terms and amounts, and special features of each lender.
- Submit an application. After checking the preliminary offers and selecting your preferred lender, complete an official loan application. This can be done online or in person by most lenders.
- Provide documentation. If the lender requests additional documents, submit them in a timely manner. This can happen if you don’t have strong credit, for example.
- Accept loan funds. If you are approved, the lender will tell you how you will receive the loan funds. If it is an installment loan, you will receive the money as a lump sum. For revolving loans, such as a credit card, the lender will issue you a credit card to withdraw funds from the account as needed.
Whenever you take out an unsecured loan, be sure to repay it on time to avoid damaging your credit score.