All You Need to Know about Unsecured Loan

Unsecured loans are available from banks, credit unions, and online lenders. Unlike secured loans, they don’t require collateral, making them harder to get approved for. However, they carry less risk since there’s no threat of asset seizure if you default on the payments.

Most installment loans fall into the unsecured category, including student loans, personal loans, and revolving credit like credit cards. While eligibility criteria vary by lender, you’ll generally need good to excellent credit and a stable income to qualify. Borrowers with the best credit scores are more likely to receive favorable loan terms and lower interest rates. Although the intended use can vary by lender, unsecured loans can typically be used for almost any legal expense.

Unsecured loans are loans that don’t require collateral. Often called signature loans, they only require your signature if you meet the lender’s criteria. Since lenders take on more risk without collateral, these loans typically come with higher interest rates and require good to excellent credit for approval.

Unsecured loans can come as revolving debt, such as credit cards, or as installment loans, like personal or student loans. Installment loans require you to repay the balance in fixed, monthly installments over a set period.

Credit cards, on the other hand, allow you to borrow as needed. They usually have higher interest rates than installment loans, and if you miss a payment, you’ll incur interest charges on the principal amount.

Borrowers who need funds but are uncomfortable pledging collateral can consider an unsecured loan in the following situations:

  • Planning for a large purchase: While taking on debt can strain your finances, an unsecured loan can provide the necessary funds for significant upcoming expenses.
  • Having good credit: A high credit score can unlock more favorable terms and interest rates for unsecured loans.
  • Having reliable income: Although collateral isn’t required, steady income is essential to repay the debt and avoid defaulting. Defaulting on unsecured loans can negatively affect your credit.
  • Consolidating debt: Unsecured loans can simplify debt repayment by consolidating multiple debts. This strategy can also save money if the borrower qualifies for a lower interest rate.

There are several types of unsecured loans to consider, with the most popular options being personal loans, student loans, and credit cards.

Personal Loans

Personal loans can be used for a variety of purposes, such as consolidating debt, financing a large purchase, covering expenses for an ongoing project, or funding home renovations. There are specific personal loans available for different needs, including wedding loans, pet loans, and holiday loans, although these are essentially unsecured personal loans designated for particular purposes. Personal loans typically have lower interest rates compared to credit cards.

  • Loan amount: Approximately $1,000 to $50,000
  • Average interest rate: 12.35% (as of June 26, 2024)
  • Repayment timeline: Two to seven years
  • Best for: Borrowers with good credit who know exactly how much funding they need.

Student Loans

Student loans come in two main types: federal and private. Federal student loans are generally the better option for most borrowers due to their lower interest rates and availability to all students attending participating colleges. Private student loans, offered by private lenders, often come with higher rates and stricter eligibility requirements. These loans are typically used to fill funding gaps and lack the benefits and protections that federal loans provide.

  • Loan amount: Up to the full cost of attendance (private loans only)
  • Average interest rate: Up to 17% (private loans), up to 8.05% (federal loans)
  • Repayment timeline: Five to 20 years, varying for each borrower
  • Best for: Students needing to supplement their need- or merit-based financial aid for post-secondary education.

Credit Cards

Credit cards are one of the most common forms of financing. As a revolving debt, they allow you to access funds up to your credit limit whenever needed. Credit cards can be used for consolidating debt, everyday spending, or funding larger purchases or experiences. However, interest rates can be high, and carrying a balance can quickly accumulate interest charges.

  • Credit limit: Typically between $2,000 and $10,000
  • Average interest rate: 20.71% (as of June 26, 2024)
  • Repayment timeline: No specified timeline
  • Best for: Individuals with healthy spending habits looking for a long-term revolving line of credit.

Secured loans differ from unsecured loans because they always require collateral. A lender will not approve a secured loan unless the borrower agrees to provide an asset as security.

Secured loans are available for various financing needs, including:

  • Mortgages
  • Car loans
  • Home equity lines of credit
  • Certain types of personal loans

Borrowers will not find unsecured mortgages, as the home is always used as collateral. While unsecured auto loans do exist, they are rare.

Unsecured loan options can be less risky for certain borrowers, but it’s important to understand all aspects before committing to any long-term debt. Making a fully informed decision is crucial for maintaining financial health.

Pros of Unsecured Loans

  • No collateral required.
  • Fast access to funds.
  • No risk of losing assets.
  • Fewer borrowing restrictions.
  • Competitive rates for those with strong credit.

Cons of Unsecured Loans

  • Higher interest rates for those with low credit scores.
  • Lower borrowing limits for those with low credit scores.
  • Harder to get approved.
  • Fewer borrowing options than secured loans.

To limit their risk, lenders want to ensure you can repay the loan. They assess this risk by considering several factors, and they may ask for the following information when you apply for an unsecured loan. Loan terms will be tailored based on your responses:

Lenders review your credit reports to evaluate how you’ve managed loans and credit cards in the past. They look for a history of responsible credit use, on-time payments, low credit card balances, and a mix of account types. They also check your credit scores, which are based on the information in your credit reports. Generally, consumers with FICO scores around 700 or higher qualify for the best interest rates.

Lenders need to ensure you have the financial means to meet your obligations, including loan payments. They may ask for proof of stable and sufficient income, such as a current pay stub, to verify your ability to repay the loan.

Your debt-to-income ratio (DTI) is calculated by adding all your monthly debt payments and dividing that total by your gross monthly income. For example, if you have $500 in monthly debt payments and $2,000 in gross monthly income, your DTI is 25% ($500 / $2,000 = 0.25). Lenders use this ratio to assess your ability to repay a loan. A lower ratio is preferable, and while each lender has different requirements, credit.org suggests a maximum DTI of around 36%.

Even though unsecured loans don’t require collateral, lenders may want to know you have savings. This indicates that you are prepared for financial emergencies and are less likely to miss loan payments.

If you decide an unsecured loan is right for you, follow these simple steps to apply:

  • Determine How Much You Need: Only borrow the amount you need, even if the lender approves you for a higher amount.
  • Research Top Lenders: Look for unsecured loans through national and local banks, credit unions, and online lenders.
  • Compare Unsecured Loan Offers: Some lenders offer prequalification, allowing you to see potential loan options before formally applying. Compare interest rates, fees, loan terms, amounts, and any special features.
  • Submit an Application: After reviewing preliminary offers and choosing your preferred lender, complete the formal loan application. This can typically be done online or in person.
  • Provide Documentation: Submit any additional documentation requested by the lender in a timely manner. This may be necessary if you don’t have strong credit.
  • Accept Loan Funds: If approved, the lender will explain how you will receive the loan funds. For installment loans, you’ll receive a lump sum. For revolving loans, such as credit cards, the lender will issue a card for drawing funds as needed.

The primary benefit of an unsecured loan is the absence of collateral requirements. However, failing to repay the loan can lead to severe consequences, such as significant damage to your credit score. Additionally, lenders may resort to legal action to garnish your wages.

Choosing to take out an unsecured loan can be advantageous if you have a clear repayment plan. Before applying, it’s wise to compare interest rates, terms, and fees across multiple lenders to find the most favorable option.