Unsecured loans are offered by banks, credit unions, and online lenders. Unlike secured loans, unsecured loans aren’t backed by collateral and can be harder to get approved for than secured loans. However, they are less risky because you don’t have to worry about your assets being seized if you miss payments.
Most installment loans are unsecured. This includes student loans, personal loans, and revolving credit such as credit cards. Qualifications vary by lender, but generally you need good or excellent credit and a steady source of income to qualify.
The most creditworthy borrowers are likely to be offered the best loan terms and lowest interest rates. Unsecured loans are generally available for almost all legal expenses.
What is an Unsecured Loan?
An unsecured loan is a loan that doesn’t require collateral. It’s also called a signature loan because all you need is your signature, as long as you meet the lender’s borrowing requirements. Because lenders take on more risk when a loan is unsecured, they usually charge higher interest rates and require good or excellent credit to be approved.
Unsecured loans can be available as revolving debt, like a credit card, or as installment loans, like a personal loan or student loan. Installment loans require you to repay the total balance in fixed monthly installments over a set period of time.
Credit cards give you access to what you need, when you need it. Interest rates on credit cards are often higher than on loans. If you miss a monthly payment, you’re charged interest on top of the principal.
Who should get an unsecured loan?
Borrowers who need money but are reluctant to put up collateral to take out a loan can consider an unsecured loan if:
- Planning a big purchase. Borrowing money can put a strain on your finances, but if you need funds to cover a big expense, an unsecured loan can help.
- They have good credit. A high credit score can qualify you for more favorable unsecured loan terms and interest rates.
- They have a stable income. While unsecured loans don’t require collateral, you do need a steady income to repay the debt and avoid defaulting on the loan. Missing payments on a secured loan can have a negative impact on your credit.
- Debt consolidation. Unsecured loans serve as a debt consolidation tool that can simplify debt repayment. This strategy can also help borrowers save money if they qualify for low interest rates.
Types of unsecured loans
There are several types of unsecured loans. However, the most popular options are personal loans, student loans, and credit cards.
Is an unsecured loan or a secured loan better?
Secured loans differ from unsecured loans in that they require collateral. Lenders will not approve a secured loan if the borrower does not agree to put up an asset as insurance.
Secured loans have the following funding options:
- Home loan.
Car loan.
- Home equity line of credit.
- Several types of personal loans.
Since the home is always used as collateral, borrowers will never encounter an unsecured mortgage. Unsecured car loans also exist, but are uncommon.
The pros and cons of unsecured loans
While unsecured loans may be less risky than other types of loans for certain borrowers, that is not the case for all borrowers. Making an educated decision when taking on long-term debt is important to promote financial health.
Benefits of unsecured loans
- No collateral is required.
- Faster access to funds.
- There is no risk of losing your assets.
- There are few borrowing limits.
- Competitive rates for those with good credit.
Disadvantages of unsecured loans
- The risk of losing assets.
- Those with lower credit scores may be eligible for lower borrowing limits.
- Those with lower credit scores may be faced with higher interest rates.
- It will be harder to get approval.
- You have fewer borrowing options than with a secured loan.
Eligibility for Unsecured Loans
To limit their risk, lenders want to be reasonably sure that borrowers will be able to repay the loan. Lenders check several factors to gauge risk, so they may ask for the following information when you apply for an unsecured loan (and adjust the terms of your loan depending on your answers):
Your credit
Lenders check your credit report to see how you’ve managed loans and credit cards in the past. Typically, lenders look for a history of responsible credit usage (usually at least a year), on-time payments, low credit card balances, and a mix of different account types. Lenders also check your credit score, which is calculated based on the information in your credit report. Consumers with a FICO credit score of around 700 or higher typically qualify for the best interest rates.
Your income
The lender’s risk is reduced when they know that the borrower has the means to meet their financial obligations, including loan payments. Lenders may require proof of a stable, sufficient income, such as a current pay stub.
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 your existing debt payments are $500 and your gross monthly income is $2,000, your DTI is $500 / $2,000 = 0.25, or 25 percent.
Lenders use this number to gauge your ability to repay the loan. The lower the ratio, the better. Different lenders have different DTI requirements, but credit.org claims that it usually shouldn’t exceed a maximum of 36 percent.
assets
Unsecured loans don’t require collateral, but lenders may want to know if you have savings. Lenders know that you’re less likely to default on your loan payments if you’re prepared to deal with a financial emergency.
How to Apply
If an unsecured loan is right for you, applying requires a few simple steps.
- Determine the amount you need. Only borrow the amount you need, even if your lender approves you for a higher amount.
- Research the top lenders. You can find unsecured loans through national banks, local banks, credit unions, and online lenders.
- Compare unsecured loan offers. Some lenders offer pre-qualification so you can see which loans you qualify for before you apply. Review each lender’s interest rates, fees, loan terms and amounts, and special features.
- Please submit your application. After you review the preliminary offers and select your preferred lender, you complete a formal loan application, which can be done online or in person through most lenders.
- Provide documentation. If the lender requests additional documentation, submit it in a timely manner. For example, such a request may be made if you have poor creditworthiness.
- Accept loan funds. If you’re approved, your lender will tell you how to receive your loan funds. For installment loans, you’ll receive the money in a lump sum. For revolving loans, such as credit cards, your lender will issue you a credit card to withdraw funds from your account as needed.
Conclusion
The main advantage of an unsecured loan is that you don’t have to put up any collateral. But if you default on your loan repayments, you could face serious consequences, including major damage to your credit. What’s more, the lender could take you to court and garnish your wages.
If you plan to pay off your debts, an unsecured loan is a good idea. If you decide an unsecured loan is right for you, be sure to compare interest rates, terms, and fees from as many lenders as possible before applying.
