What Is An Unsecured Loan?
4-Minute ReadNovember 12, 2021
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 type of 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 hitting 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, as well as their 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 place restrictions on how the unsecured loan can be spent, the option remains popular for its ability to successfully finance a wide variety of financial goals. Qualified borrowers can use unsecured loans to commit to 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 mortgages 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 swap out the need for collateral with higher interest rates.
Types Of Unsecured Loans
If you’re considering taking out an unsecured loan, read through this guide to learn the types available and their recommended uses.
A personal loan is exactly that - personal. It’s a general use loan that allows borrowers to receive funding for a number of financial issues or purchases. At Rocket LoansⓇ, we enable qualified borrowers to take out 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. Bonus: Unsecured credit cards are a great strategy for building better credit.
This kind of unsecured loan only requires borrowers to sign the terms and paperwork – no credit check required.
In recent years, peer-to-peer lending has become a popular way to access funding without traditional lending providers. 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.
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 that 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?
Now that we’ve covered the basics of unsecured loans, let’s walk through the process of how to get one, use it and pay it back.
Most lenders require potential borrowers to submit a thorough application with information about their credit, income, current monthly payments and additional financial information. Again, unsecured loans are based solely on creditworthiness, so lenders need to ensure that you will be able to fulfill the loan agreement.
If you’re approved for the unsecured loan, great! But before signing on the dotted line, read through the offer details and clarify any questions about the terms.
What To Look For In An Unsecured Loan
As with any loan, it’s important to compare offer details across lenders to make sure that it fits your needs and budget. Let’s review 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 personal loan funding as soon as the same day.*
Annual Percentage Rate (APR)
The APR is the total cost of the loan, plus the interest rate and any additional fees. When it comes to the APR of an unsecured loan, lower is better.
Fixed Or Variable Rate
A fixed-rate loan means that the borrower will pay the same interest rate for the duration of the loan, whereas a variable-rate loan could allow the interest rate to change over time.
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 as well as your monthly budget.
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.
What Happens If I Default On My Unsecured Loan?
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 loan default can remain 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 be charged higher interest rates until they can increase their credit score.
An additional consequence of defaulting on an unsecured loan is that the loan may be accelerated, meaning that the entire balance will be due immediately. If a borrower is unable to 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, as well as 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 the 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 any options that may be available to you, such as a new repayment plan, deferment or forbearance.
So, is an unsecured loan right for you? This loan option is optimal for people who have an impending expense, a reasonable DTI percentage and a high credit score. These borrowers will likely receive lower interest rates, which will make the monthly payments more manageable.
If your credit score is lacking, a loan lender is likely to stick you with a higher interest rate. This may make it more difficult to afford the monthly payments, which puts your credit score at further risk. If that’s the case, take a look at these strategies for improving your credit score today.
*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.
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