What is an unsecured loan?
An unsecured loan is a loan that is not backed by collateral to guarantee repayment. Lenders grant unsecured loans to creditworthy borrowers who pose a low risk of defaulting or not abiding by the terms of the loan.
Also known as personal or signature loans, unsecured loans are approved for borrowers with high credit ratings. These loans are considered high risk to lenders since there is no property or asset to recover if the borrower defaults. This explains why unsecured loans have higher interest rates than secured loans.
Lenders give unsecured loans with the confidence that the borrowers will repay them according to the terms agreed upon. The creditworthiness of the borrower is assessed based on the five C’s of credit: character, capacity, capital, collateral and conditions. Examples of unsecured loans include credit card purchases, personal loans and student loans.
The significant difference between secured and unsecured loans is that collateral protects secured loans. Additionally, secured loans have longer repayment terms, higher borrowing limits and lower interest rates than unsecured loans. Examples of secured loans include auto loans, mortgages and home equity loans.
Unsecured loan example
Ken took out a $10,000 personal loan from a local bank and did not have to put up any of his assets, including his home, land, stocks, bonds or other assets, to guarantee the loan. He was approved for the loan based on his solid credit history and got a rate of 4.29 percent. Ken chose the personal loan because it was cheaper than borrowing against a credit card.
Looking to fix up your house? Here are five things to know about unsecured home improvement loans.