Key learning points
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Unsecured loans are debt products that do not require collateral but may come with higher interest rates and stricter credit requirements.
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There are several unsecured loans, including personal loans, student loans, and credit cards.
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When determining whether you qualify for an unsecured loan, lenders will consider factors such as credit history, income and debt-to-income ratio.
Unsecured loans are offered by banks, credit unions and online lenders. Unlike secured loans, they are not backed by collateral and can be more difficult to get approved than a secured option. However, they carry less risk because you don’t have to worry about your assets being seized if you don’t make the payments.
Most installment loans are unsecured. This includes student loans, personal loans and revolving credits such as credit cards. Eligibility varies from lender to lender, but generally you need good or excellent credit and a stable source of income to qualify. The most creditworthy borrowers are likely to be offered the best loan terms and lowest interest rates. Although the use depends on the lender or credit institution, you can generally use an unsecured loan for almost all legal costs.
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 required if you meet the lender’s loan requirements. Because lenders take on more risk when loans are not backed by collateral, they often charge higher interest rates and require good or excellent credit to be approved.
Unsecured loans are available as revolving debt (a credit card) or as an installment loan, such as a personal loan or a student loan. With installment loans, you must repay the total balance in fixed monthly installments over a set period of time.
Credit cards let you use what you need when you need it. They often have a higher interest rate than loans. If you miss a monthly payment, you will be charged interest on top of the principal amount.
Who should get an unsecured loan?
Borrowers who need money but don’t feel comfortable pledging collateral to secure a loan may consider an unsecured loan when:
- Planning for a major purchase. Taking on debt can put a strain on your finances, but if you need money for major expenses, an unsecured loan can help.
- They have good credit. A high credit score unlocks more favorable unsecured loan terms and interest rates.
- They have a reliable income. Although no collateral is required for an unsecured loan, you do need a steady income to repay the debt and avoid defaulting on the loan. Unpaid secured loans can negatively impact your credit score.
- Consolidating debts. Unsecured loans are useful as debt consolidation tools that can make debt repayment easier. This strategy can also help borrowers save money if they qualify for lower interest rates.
Types of unsecured loans
There are different types of unsecured loans to choose from. However, the most popular options are personal loans, student loans, and credit cards.
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A personal loan can consolidate debts, finance a major purchase, finance an ongoing project or finance renovations to a home. There are personal loans available for almost everything, including wedding loans, pet loans and vacation loans. Technically, these are just unsecured personal loans where the money may only be used for related purchases. Interest rates for personal loans are generally lower than those for credit cards.
- Loan amount: About $1,000 to $50,000
- Average interest: 12.18 percent (as of April 10, 2024)
- Refund timeline: Somewhere between two and seven years
Who is a personal loan best for: Good borrowers who know exactly how much financing they need.
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There are two types of student loans: federal and private student loans. Federal loans are the better choice for most borrowers because they have much lower rates and are available to any student attending a participating university. Private lenders offer private student loans and may have higher rates and stricter eligibility requirements. These loans are best used to fill funding gaps because they do not provide the benefits and protections that federal loans provide.
- Loan amount: Up to the full participation fee (private loans only)
- Average interest: Up to 17 percent (private loans), up to 8.05 percent (federal loans)
- Refund timeline: Ranging from five to twenty years, but this will vary for each borrower
Who is a student loan best for: Prospective and current postsecondary students supplementing their need- or merit-based financial aid.
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Credit cards are one of the most common financing options. They are revolving debts, so the money is available when needed. You can borrow up to your credit limit, which is assigned by the lender, and you can borrow up to that limit. You can use a credit card to consolidate debt, for everyday expenses, or to finance a larger purchase or experience. However, rates can be high and interest quickly adds up if you carry a balance.
- Credit limit: Usually between $2,000 and $10,000
- Average interest: 20.75 percent (as of April 10, 2024)
- Refund timeline: No specific timeline
Who is a credit card best for: Individuals with healthy spending habits who are looking for a long-term revolving line of credit.
Unsecured Loans vs. Secured Loans: Which is Better?
Secured loans differ from unsecured loans in that secured loans always require collateral. The lender will not approve a secured loan if a borrower does not agree to provide an asset as insurance.
Secured loans exist for financing options including:
- Mortgages.
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Car loans.
- Home equity lines of credit.
- Some types of personal loans.
Borrowers will not encounter unsecured mortgages because the home is always used as collateral. Unsecured car loans do exist, but they are uncommon.
Advantages and disadvantages of unsecured loans
Unsecured loan options may be less risky than other types of loans for certain borrowers, but not for all. When taking on long-term debt, making an informed decision is critical to promoting financial health.
Benefits of unsecured loans
- No collateral required.
- Quick access to funds.
- No risk of property loss.
- Fewer borrowing restrictions.
- Competitive rates for people with strong credit.
Disadvantages of unsecured loans
- Risk of losing assets.
- Lower borrowing limits may apply for people with low credit scores.
- Possibly higher interest rates for people with low credit scores.
- Harder to get approved.
- Has fewer borrowing options than secured loans.
Qualifications for an Unsecured Loan
To limit their risk, lenders want to be reasonably certain that you can repay the loan. Lenders measure that risk by checking a number of factors, so they may ask for the following information when you apply for an unsecured loan (and tailor the loan terms to your answers):
Your credit
Lenders check your credit reports to see how you have managed loans and credit cards in the past. Generally, they look for a history of responsible credit use (typically one or more years), on-time payments, low credit card balances, and a mix of account types. They also check your credit scores, which are calculated from the information in your credit reports. Consumers with a FICO credit score around 700 or higher usually qualify for the best interest rates.
Your income
Knowing you have the resources to meet your financial obligations, including loan payments, reduces the risk to the lender. The lender may ask for proof of stable and sufficient income, such as a current pay slip.
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 pay off $500 in existing debt and $2,000 in gross income per month, your DTI is $500 / $2,000 = 0.25 or 25 percent.
Lenders use this number to measure your ability to repay a loan. The lower the ratio, the better. Each lender has different requirements for your DTI; However, credit.org states that the maximum is generally no higher than 36 percent.
Assets
Although unsecured loans do not require collateral, the lender may want to know that you have savings. They know that you are less likely to miss loan payments if you are prepared for financial emergencies.
How to apply
If an unsecured loan is right for you, you can apply in a few 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 through national and local banks, credit unions and online lenders.
- Compare unsecured loan offers. Some lenders offer prequalification so you can see which loans you may qualify for before you apply. Look at each lender’s interest rates, fees, loan terms and amounts, and special features.
- Submit an application. Complete a formal loan application after reviewing preliminary offers and selecting your preferred lender. This can be done online or in person through most lenders.
- Provide documentation. If the lender requests additional documentation, submit it in a timely manner. This can happen, for example, if you do not have strong credit.
- Accept loan funds. If approved, the lender will tell you how to receive the loan money. If it is an installment loan, you will receive the money in one go. For revolving loans, such as a credit card, the lender will provide you with a credit card that you can use to withdraw money from the account if necessary.
it comes down to
The big advantage of an unsecured loan is that you do not have to pledge any collateral. But if you can’t pay off the loan, you could still face serious consequences, such as major damage to your credit rating. In addition, a lender can take you to court to garnish your wages.
Taking out an unsecured loan can be good if you plan to repay the debt. If you decide that an unsecured loan is right for you, compare rates, terms and costs from as many lenders as possible before applying.
