Loans fall into one of two categories: secured or unsecured. A secured loan is used to purchase assets like a house or car that the lender can take if you default on your loan. Unsecured loans are not guaranteed by an asset like a house or vehicle. Lenders can’t repossess or foreclose on 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.
What Is an Unsecured Loan?
An unsecured loan doesn’t require collateral from the borrower. Instead of relying on collateral, lenders consider a borrower’s creditworthiness, income and financial history.
Since the borrower doesn’t have to put up collateral, the lender won’t have a designated asset to seize if the borrower doesn’t keep up with their monthly payments. This lack of protection for the lender often leads to higher interest rates for the borrower.
Good To Know
A few common types of unsecured loans include student loans, credit cards and personal loans.
How Unsecured Loans Work
- The process starts with a lender reviewing the borrower’s financial situation.
- Although there’s no collateral involved, the lender will consider the borrower’s creditworthiness, debt-to-income ratio, financial history, income and other lender requirements.
- If approved, the borrower receives either a lump sum of cash or access to a revolving line of credit.
- In either case, borrowers must repay the loan with interest.
- Since lenders cannot seize collateral after a borrower stops making payments, unsecured loans often come with higher interest rates than secured loans.
Types of Unsecured Loans
Below is a look at some of the different types of unsecured loans.
- Personal loans:
- A personal loan is a common type of unsecured loan, and you can use it for nearly any purpose — from covering unexpected expenses to funding a dream vacation.
- People often take personal loans to pay for major car or home repairs, consolidate high-interest debt or finance large purchases.
- Some also use them to build credit with manageable on-time payments.
- Typically offered by banks or credit unions, personal loans usually have lower interest rates than credit cards, with terms and borrowing limits based on your credit history.
- Credit cards:
- A credit card gives you access to a personal line of credit that you can use for nearly any purchase, without needing to provide collateral or guarantees.
- You’ll face interest charges on unpaid balances.
- Student loans:
- Student loans are 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% of your disposable income without first going to court and getting a recourse judgment against you.
- Federal student loans tend to come with lower interest rates than private student loans.
- Payday loans:
- Payday loans are short-term high-interest loans that can be used to cover expenses before you get your next paycheck.
- Unfortunately, the high-interest nature of these loans can push borrowers into an unrelenting cycle of debt.
- Unsecured business loans:
- An unsecured business loan doesn’t require assets for collateral.
- Typically, approval for these loans is based on business revenue and the financial stability of the company.
- Medical debt:
- 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.
Unsecured vs. Secured Loans: What’s the Difference?
Unsecured loans differ from secured loans in several ways.
Loans are considered secured when the lender can repossess something of value — known as collateral — if you stop making payments. For example, your car or boat could be reclaimed by the bank, or you could face foreclosure on your house.
Examples of Secured Loans
- Auto loans
- Boat loans
- Home mortgages
- Home equity lines of credit
- Recreational vehicle loans
A secured loan usually has a lower interest rate and might be for a larger amount than an unsecured loan because of the added protection collateral provides. It might also have a longer repayment term.
The table below highlights the differences between secured and unsecured loans:
| Feature | Unsecured Loan | Secured Loan |
|---|---|---|
| Collateral Required? | No | Yes (house, car, savings, etc.) |
| Interest Rates | Higher | Lower |
| Risk for Borrower | No asset loss risk | Risk of losing collateral |
| Approval Based On | Credit score and income | Credit and asset value |
| Common Uses | Personal expenses, education, credit cards | Mortgages, auto loans, home equity loans |
Pros and Cons of Unsecured Loans
Every financial product comes with advantages and disadvantages to consider. The table below highlights the pros and cons of unsecured loans:
| Pros | Cons |
|---|---|
| No collateral required | Higher interest rates |
| Faster approval process | Harder to qualify with bad credit |
| Can be used for various expenses | Lower loan amounts than secured loans |
| No risk of losing property | Stricter lender requirements |
How To Qualify for an Unsecured Loan
If you want to qualify for an unsecured loan, use the following strategies to increase your approval odds.
- Improve your credit score. Most lenders take a close look at your credit score when making lending decisions. Typically, borrowers with higher credit scores tend to enjoy lower interest rates.
- Lower your debt-to-income ratio. Your DTI measures how much of your monthly income is consumed by existing debt payments. A lower DTI reflects positive financial decisions, which could increase your approval odds.
- Shop around. Before committing to a loan, shop around to find the lowest available interest rates and fees.
- Consider a co-signer. If you have a low credit score, finding a co-signer for your loan could improve your approval chances. The catch is that the co-signer becomes legally responsible for the debt, which could make it difficult to find a willing co-signer.
When Is an Unsecured Loan a Good Idea?
An unsecured loan could make sense when you need financing but don’t have any available collateral. Typically, unsecured loans offer faster funding timelines due to the more limited paperwork requirements.
If you need funds quickly, this speed might make unsecured loans a more attractive option.
But, in general, secured loans offer better interest rates and terms. If you qualify for a secured loan and don’t mind the wait, then a secured loan could be a better option for the long term.
Final Thoughts: Is an Unsecured Loan Right for You?
Unsecured loans don’t require collateral, which often leads to more lending flexibility. However, since these types of loans often come with relatively high interest rates and fees, it’s important to compare loan terms and repayment options before applying.
Unsecured loans can make sense in many situations, especially if you need fast funding. But if you don’t mind a longer timeline, the lower interest rates of a secured loan could be a better fit.
FAQ
Here are the answers to some of the most frequently asked questions about unsecured loans.- What credit score do I need for an unsecured loan?
- 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.
- Can I get an unsecured loan with bad credit?
- It's possible to get an unsecured loan with bad credit. But bad credit borrowers tend to face higher interest rates.
- How do lenders decide my loan amount?
- When determining your loan amount, lenders will consider your financial situation, credit score and income.
- Are unsecured loans better than secured loans?
- 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.
- What happens if I don't repay an unsecured loan?
- 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.
- 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.
- Even though unsecured loans aren't backed by specific collateral, lenders aren't powerless if you default on repayment.
Barb Nefer contributed to the reporting for this article.