Unsecured loans are loans that don’t require collateral to be approved for the loan. The lender will check your creditworthiness and consider a few other factors, such as income, savings and debt, to see if you qualify.
Because the lender is taking on more risk when the loan isn’t backed by collateral, they may charge higher interest rates and require good or excellent credit.
Here’s what to know about unsecured loans before you apply.
Types of unsecured loans
Comparing loan types can help you figure out which one is best for you. Here are the most common types of unsecured loans.
You may choose a personal loan, which is a lump sum borrowed from a financial institution that you pay back with interest, in fixed monthly installments. Unsecured personal loans can be used for many purposes, such as debt consolidation, paying for a vacation or financing a home improvement project.
A revolving loan has a credit limit. A bank will approve the borrower for a certain amount, which can be spent, repaid and used again. Credit cards and personal lines of credit are examples of revolving unsecured loans. One drawback is that the interest rate may be variable, which means it could change over time.
Student loans are also considered unsecured loans. Available either through the federal government or private lenders, they’re used to pay for qualified education expenses.
Although these unsecured loans and lines of credit are only guaranteed by your promise to pay, the lender still has recourse if you fail to make payments. The lender can send your account to a collection agency, take you to court to garnish your wages, and report your late payments to the credit bureaus. These actions will most likely cause your credit scores to drop.
Who should get an unsecured loan?
If you need money but aren’t comfortable pledging collateral to secure a loan, then an unsecured loan can be a good option. A traditional loan is best for people who have a specific purpose for the funds, such as consolidating debt, while a line of credit is better for people who don’t know how much they’ll need or when. Keep this in mind: Taking on unnecessary debt can put a strain on your finances, so make sure you need the money before applying for a loan.
You typically need good credit to qualify for an unsecured personal loan because the lender is taking on more risk. You can check your credit before applying to see if it needs a little work.
Types of lenders that offer unsecured loans
You can apply for an unsecured loan at many different financial institutions.
- Banks: If in-person service is important to you, then this type of brick-and-mortar lender can be a good option. You also may qualify for a customer relationship discount if you already have an account at a bank. While many of the larger main banks limit their unsecured personal loan options, a handful still offer them. Check Citibank, Discover, and Wells Fargo for unsecured personal loans, or inquire at your local community bank. Additionally, most banks offer unsecured credit cards.
- Credit unions: If you’re already a member of a credit union, ask about their unsecured loan options. Credit unions typically offer lower interest rates and more flexible repayment terms on their unsecured credit cards and unsecured personal loans. However, the loan amounts may be smaller at these financial institutions.
- Online lenders: You can apply for an unsecured personal loan from many different online lenders. They may offer higher loan amounts and same-day funding, and some are willing to work with people who have lower credit scores, but they may have higher interest rates than other types of financial institutions.
- Peer-to-peer lenders: Like online lenders, peer-to-peer lenders operate online. When you apply for an unsecured personal loan, an individual investor will fund it instead of a bank. This type of lender may offer lower interest rates and looser eligibility requirements.
Unsecured loan approval process
To limit their risk, lenders want to be reasonably sure you can repay the loan. A lender measures that risk by checking a few factors, so they may ask about the following information when you apply for an unsecured loan (and tailor the terms according to your answers).
Lenders check your credit reports to see how you’ve managed loans and credit cards in the past. Generally, they’re looking for an established history of responsible credit use (typically one or more years), on-time payments, low credit card balances and a mix of account types. They’ll also check your credit scores, which are calculated based on the information in your credit reports. Consumers with credit scores around 700 or higher usually qualify for the best interest rates.
Knowing you have the means to meet your financial obligations, including the loan payments, lowers the lender’s risk. The lender may ask to see proof of a stable, sufficient income, such as a current pay stub.
Your debt-to-income ratio
Lenders use this number to measure your ability to repay a loan. To get this number, add together all your monthly debt payments and divide by your gross monthly income. For example, if you have $500 worth of existing debt payments and $2,000 of income each month, then your DTI is $500 / $2,000 = 0.25 or 25 percent. The lower the ratio, the better. Every lender will have a different requirement for your DTI.
Although unsecured loans don’t require collateral, the lender may want to know that you have savings. They know you’re less likely to miss loan payments when you’re prepared to cover financial emergencies.
Shopping for an unsecured loan
While unsecured loans can be a good option for some people, there are a few things to look for when you shop.
This is what you pay for the ability to borrow money. Interest rates on unsecured loans range from about 4 percent to 36 percent, depending on the lender, your creditworthiness and other factors. Because the lender takes on more risk when a loan isn’t backed by collateral, unsecured loan interest rates tend to be higher than secured loans.
Some lenders charge these upfront fees for processing a new loan. They range from about 1 percent to 6 percent of the loan amount and may subtract from the loan proceeds. For example, a $1,000 loan with a 3 percent origination fee would cost $30, and you would receive $970.
Some lenders charge a fee if you make a late payment or miss one altogether. The penalty is twofold, since your credit may also suffer as a result of missed or late payments. You can avoid late fees by always paying your monthly bill on time.
While paying off your debt is always a good thing, some lenders charge a fee if you pay off the loan entirely before the scheduled term ends. That’s because the lender counts on earning interest from your payments. Before applying for an unsecured loan, check whether the lender charges a prepayment penalty.
How to apply for an unsecured loan
If an unsecured loan is right for you, start by researching loan terms among several banks, credit unions and online lenders. Compare interest rates, fees, loan terms and amounts, and special features the lender offers. You can see which loans you prequalify for before applying for a loan.
Once you’ve found a good fit, you’ll fill out an application and wait for approval.