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What Is An Unsecured Loan And How Does It Work?

8-Minute ReadJune 06, 2022

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If you need extra funds to pay for a big event, consolidate credit card debt or start a home renovation, an unsecured loan might be your best bet.

An unsecured loan is a general loan that doesn’t require borrowers to put down any collateral. Instead, lenders approve unsecured loans based on the borrower’s creditworthiness, mainly their credit history and financial status. Common examples of unsecured loans are personal loans, student loans and credit cards.

Before you hit the “apply” button, let’s take a closer look at how unsecured loans work and what they can be used for.

Unsecured Loans, Defined

So, what exactly is an unsecured loan?

As mentioned above, unsecured loans don’t require borrowers to pledge assets, such as a house or car, as collateral for the loan. These loans are approved and granted based on the borrower’s credit score, income level and amount of outstanding debt.

In exchange for a loan with no collateral, most lenders require borrowers to have a high credit score. In some cases, lenders will allow people with limited credit to bring on a co-signer who can assume the loan’s legal obligations in case the borrower defaults. It’s common, for example, for young people to add a parent or guardian as a co-signer to their student loan or first credit card.

While some lenders restrict how the unsecured loan can be spent, the option remains popular for its ability to successfully finance a wide variety of goals. Qualified borrowers can use unsecured loans to complete a large purchase, consolidate debt or even start a personal credit line.

Unsecured Vs. Secured Loans

To understand unsecured loans, you must know how they differ from secured loans. The primary difference between the two is the need for collateral – secured loans need it, and unsecured loans don’t.

Secured loans, such as auto loans and home equity lines of credit (HELOCs), require borrowers to put down a valued asset as security for the terms of the loan. That way, if the borrower defaults on the loan, the lender can take possession of the promised asset.

Since secured loans are considered less risky for lenders, most people can expect higher borrowing limits and more favorable loan terms. This is opposed to unsecured loans, which replace the need for collateral with higher interest rates.

Types Of Unsecured Loans

Unsecured loans include a wide variety of financial products, such as personal loans, unsecured credit cards, student loans and revolving lines of credit. Let’s learn more about their suggested uses.

Personal Loan

A personal loan is exactly that – personal. It’s a general use loan that allows borrowers to receive funding for various financial issues or purchases. At Rocket LoansSM, we enable qualified borrowers to get a personal loan with a wide range of loan amounts to best suit their situation – from debt consolidation to home improvement.

Unsecured Credit Card

This type of credit card provides a predetermined line of credit to borrowers that they can use for any purpose or purchase. Unsecured credit cards are also a great strategy for building better credit.

Signature Loan

This kind of unsecured loan only requires borrowers to sign the terms and paperwork – no credit check needed.

Peer-To-Peer Loan

In recent years, peer-to-peer lending has become a popular way to access funding without traditional lending providers, like a bank or credit union. This process can range from borrowing money from a friend or relative to seeking out an investor via an online peer-to-peer lending platform.

Student Loan

Education loans are used for the express purpose of funding educational endeavors and expenses. This type of loan usually carries more restrictions and payback instructions than other unsecured loans.

Personal Line Of Credit

A personal line of credit is an example of a revolving loan, which means the loan can be spent, repaid and spent again. A personal line of credit is similar to a credit card and usually carries a variable interest rate.

How Do Unsecured Loans Work?

Unsecured loans are either no-collateral installment loans or a revolving line of credit, which means lenders don’t have a way to offset their risk. This is why most lending institutions require potential borrowers to submit a thorough application with information about their credit, income, monthly payments and additional financial information. Unsecured loans are based solely on creditworthiness, so lenders need to ensure you will be able to fulfill the loan agreement.

If you have excellent credit, then you will probably have fewer difficulties finding an unsecured loan. However, if you’ve had credit issues like bankruptcy or foreclosure, the approval process could be challenging. Before applying for an unsecured loan, you can take steps to improve your credit score.

Who Should Use An Unsecured Loan?

Whether you should use an unsecured loan will depend on your personal situation and what you want to use the funds for. If you’re trying to do one of the following, an unsecured loan may be the right choice:

  • Pay for an emergency expense: Sometimes an unexpected bill shows up and you might not have enough in your bank account to cover it.
  • Consolidate debt: Combining your debt into one loan payment can simplify your expenses and may even save you money if you can secure a lower interest rate.
  • Fund a home improvement project: You could use an unsecured loan to avoid putting your house up as collateral.

Make a large purchase: If you have good credit and want to buy an appliance or make repairs to your vehicle, you could apply for an unsecured loan instead of digging into your savings.

What To Look For In An Unsecured Loan

As with any loan, it’s important to compare offer details from different lenders to make sure that the loan fits your needs and budget. Up next are some of the features of unsecured loans that borrowers should evaluate before committing to the loan.

Time To Fund

Essentially, how long will it take the lender to fund your loan? Most lenders provide funding within a few days to a week of loan approval. At Rocket Loans, we offer qualifying borrowers personal loan funding as early as the same day.*

Let’s say you need a personal loan to cover an emergency medical bill that’s due in 2 weeks. This means you’ll probably need to find a financing option that offers a same-day turnaround or 1 – 2 business days for the funding process.

Annual Percentage Rate (APR)

While some borrowers may primarily focus on the interest rate of a loan, you should also make sure to compare APRs between options. The APR is the total cost of the loan, plus the interest rate and any additional fees. With the APR of an unsecured loan, lower is better.

For example, let’s say you’re considering two loans: one with an interest rate of 5% and an APR of 10%, and another with an interest rate of 6% and an APR of 9%. Even though the first loan has a lower interest rate, the second one would actually cost less to use because it has a lower APR, which means fewer fees.

Fixed Or Variable Rate

A fixed-rate loan means the borrower will pay the same interest rate for the duration of the loan, whereas a variable-rate loan means the interest rate could change over time.

The best type of loan for you depends on your personal situation. If you have a tight budget and don’t want to worry about your monthly payment amount changing, then a fixed-rate personal loan will likely work best for you.

Monthly Payments

How much will you have to pay on the loan every month? Can you afford to keep up on payments? This feature of a loan is critical to compare against competing offers.

If you have steady income, comparing loan payments can be as simple as recalculating your monthly budget for each option. On the other hand, if your income fluctuates, you might need to ensure that the payment amount is small enough that you can cover it, even on the lower end of your income range.

Origination Fee

Some lenders charge a one-time origination fee to cover the cost of processing your loan application. Origination fees typically range from 1% to 8% of the loan amount.

Since origination fees are a one-time charge, they won’t affect your budget significantly. As long as the unsecured loan’s APR is low and you can comfortably afford the monthly payment amount, an unsecured loan is probably a financing option worth considering.

How To Apply For An Unsecured Loan

If you’ve decided to use an unsecured loan, you can use the following steps to apply:

  1. Determine the loan amount. Before you can apply for a loan, you should calculate the total dollar amount you need.
  2. Find the right lender for you. Research different types of lending institutions and platforms to find out which offers the option that works best for your situation.
  3. Compare offers. Collect information about each loan option and compare their interest rates, APRs and monthly payments.
  4. Submit an application. Once you’ve picked an unsecured loan product that fits your needs, you can fill out an application and submit it to the lender.
  5. Receive the funds. After you get approval, your lender will notify you of when and how you’ll receive the loan.

What Happens If You Don’t Pay Off Your Unsecured Debt?

It’s important to understand that unsecured loans can be risky for borrowers, too. If the borrower defaults on the unsecured loan, their credit score will take a big hit and the effects will be long-lasting.

A Negative Entry On Your Credit Report

A loan default can remain on the borrower’s credit report for up to 10 years. This will make it difficult for them to qualify for future loans, and they’ll most likely face higher interest rates until they can raise their credit score.

A Balloon Payment

An additional consequence of defaulting on an unsecured loan is that the loan may be accelerated, meaning the entire balance will be due immediately.

If a borrower can’t pay off the entire balance at once, the remaining amount owed can be turned over to a debt collection agency. This would prompt collection actions from that agency and the possibility of a lawsuit to retrieve the debt owed, which could result in wage garnishments or liens on assets. This potential fallout is why all borrowers should ensure they can repay a loan before submitting an application.

If you’ve taken out an unsecured loan and are in danger of defaulting, it’s important to reach out to your lender immediately to discuss potential options such as a new repayment plan, deferment or forbearance.

Final Thoughts

So, is an unsecured loan right for you? This loan option is optimal for people who have an impending expense, a reasonable debt-to-income ratio (DTI) and a high credit score. These borrowers will likely receive lower interest rates, making the monthly payments more manageable.

If your credit score is lacking, a lender is likely to stick you with a higher interest rate. This may make it more difficult to afford the monthly payments, putting your credit score at further risk. If that’s the case, consider improving your credit score beforehand.

When you’re ready to take the next step toward consolidating your debt or renovating your home, visit Rocket Loans to apply for a personal loan.

*Same Day Funding available for clients completing the loan process and signing the Promissory Note by 1:00PM ET on a business day. Also note, the ACH credit will be submitted to your bank the same business day. This may result in same day funding, but results may vary and your bank may have rules that limit our ability to credit your account. We are not responsible for delays which may occur due to incorrect routing number, account number, or errors of your financial institution.

Ready To Improve Your Financial Life?

Apply for a personal loan today to consolidate your debt.

*Same Day Funding available for clients completing the loan process and signing the Promissory Note by 1:00PM ET on a business day. Also note, the ACH credit will be submitted to your bank the same business day. This may result in same day funding, but results may vary and your bank may have rules that limit our ability to credit your account. We are not responsible for delays which may occur due to incorrect routing number, account number, or errors of your financial institution.