A transaction falls into one of two categories when you borrow money: It’s either a secured or an unsecured loan. As the name implies, a secured loan is used for a property like a house or car that the lender can take if you default on your loan. The usual unsecured loan definition refers to a personal loan that isn’t guaranteed by an asset like a house or vehicle, such as a credit card. Lenders can’t repossess or foreclosure on specific collateral or property when borrowers default on unsecured loans. Here’s everything you need to know about unsecured loans, so you can better decide if they’re the right financial tool for you.
Examples of Unsecured Loans
A personal loan, also known as a signature loan, is a common example of an unsecured loan. The reason you’re borrowing the money doesn’t matter. You might take the loan to pay for something practical or to splurge on your dream vacation. But some common reasons to take out a personal loan include:
- Paying for unexpected bills, like a major car or home repair
- Consolidating other debts that carry higher interest rates
- Buying big-ticket home items, like appliances
- Improving your credit score by taking a small personal loan that you can easily repay
Related: Best Personal Lines of Credit
A personal loan is typically granted by a bank or credit union, and the amount you can borrow and the interest rate you’re charged are dependent on your credit history. Personal loans usually have lower interest rates than credit cards.
Other common unsecured loan examples include credit cards, medical bills and home improvement loans.
- A credit card provides a personal line of credit that you use as you see fit with no restrictions on purchases and nothing guaranteeing the amount you charge.
- Medical bills are a type of unsecured debt that can catch you by surprise due to unexpected illness or injury, especially if you’re uninsured.
- If you don’t have enough equity built up in your house to qualify for a home equity loan, unsecured home improvement loans are an option. Expect to pay higher interest and to face stricter qualification hurdles.
Student loans are hybrids. They’re technically unsecured loans, but your tax refund can be garnished to repay them so in this respect, they’re secured. The Department of Education can also garnish up to 15 percent of your disposable income without first going to court and getting a recourse judgment against you.
How Unsecured Loans Compare to Secured Loans
- Auto loans
- Boat loans
- Home mortgages
- Home equity lines of credit
- Recreational vehicle loans
Your car or boat could be reclaimed by the bank, or you could face foreclosure on your house.
A secured loan usually has a lower interest rate and might be for a larger amount than its unsecured counterpart because of the added protection the collateral gives to the lender. It might also run for a longer term.
Credit cards are also sometimes secured. A secured card is a specialized type of unsecured loan that requires you to open a bank account and deposit money to guarantee the amount you charge. It provides you with a credit line that’s typically equal to and secured by the amount of your deposit. These credit cards help you recover if you have bad credit.
Qualifying for Unsecured Loans
Unsecured loans have no collateral to guarantee them so you typically need a good credit history to qualify for one. They might also carry a higher interest rate, another way lenders offset the risk involved. You should be able to qualify for an unsecured loan with a reasonable interest rate if your credit score is at least 640. You must also be at least 18 years old and have a regular source of income as well as a bank account
Personal loan interest rates vary widely depending on your credit score, the lender, the term or duration of the loan, and the amount you borrow. You might pay as little as 2.29 percent or as much as 36 percent depending on these factors.
Risks of Defaulting on Unsecured Loans
Even though unsecured loans aren’t backed by specific collateral, lenders aren’t powerless if you default on repayment. Lenders can hire debt collectors to assist them with collecting from you and they will report the delinquency to the three credit bureaus, hampering your future attempts to get credit. If that doesn’t work and you still don’t pay, they might sue you and get a judgment against you. At this point, the creditor can garnish your paychecks and bank accounts and might also be able to take some of your property.
Secured loans offer better interest rates and are easier to get than unsecured loans if you’ve experienced any rocky patches that have affected your credit score. If you need money for an emergency or general expense rather than a tangible big-ticket item like a car or house, or if you don’t have home equity to tap into, an unsecured loan or personal line of credit can save the day. Repay it responsibly and it will even improve your credit score, making it easier to qualify for future loans.