What is an unsecured loan?

Unsecured loans are debt products offered by banks, credit unions and online lenders that aren’t backed by collateral. They include student loans, personal loans and revolving credit such as credit cards. You’ll generally need good or excellent credit and a steady source of income to qualify for the best loan terms, and you’re free to use the loan proceeds however you see fit in most instances

What is an unsecured loan?

Unsecured loans are loans that don’t require collateral. They’re also referred to as signature loans because a signature is all that’s needed if you meet the lender’s borrowing requirements. Because lenders take on more risk when loans aren’t backed by collateral, they might charge higher interest rates and require good or excellent credit.

If a borrower stops making payments and defaults on the unsecured loan, there’s no collateral for the lender to take to recover the outstanding debt.

For example, let’s say a borrower becomes unemployed and can’t repay their unsecured personal loan and unsecured credit card debt. When the loan accounts go into default, the borrower’s credit will be adversely affected. In this situation, lenders might decide to bear the financial loss. They can also pursue repayment of the debt through a court judgment, but they can’t seize a debtor’s assets without going through the legal process.

Types of unsecured loans

There are several types of unsecured loans to choose from. However, the most popular options are personal loans, student loans and credit cards.

As the name implies, student loans are designed to help offset the costs of higher education. Credit cards can be used to make everyday purchases or cover unexpected expenses until you get back on track financially.

Personal loans generally don’t come with restrictions on how the funds can be used. So, you can borrow funds if you’re dealing with an emergency or to meet pressing financial goals. Some lenders also market these debt products as home improvement loans, wedding loans or debt consolidation goals, but they operate the same as traditional personal loans.

Pros of unsecured loans

• No collateral required
• Fast access to funds
• No risk of losing assets
• Fewer borrowing restrictions
• Competitive rates for those with strong credit

Cons of unsecured loans

• Risk of losing assets
• Might have lower borrowing limits for those with low credit scores
• Might have higher interest rates for those with low credit scores
• Harder to get approved

Unsecured loans vs. secured loans

Secured loans differ from unsecured loans in that secured loans always require collateral. If a borrower won’t agree to provide an asset as insurance, the lender won’t approve a secured loan.

This loan type exists for a variety of financing options, including mortgages, car loans, home equity lines of credit and some types of personal loans. Borrowers will likely not encounter unsecured mortgages or car loans since the home or vehicle is always used as collateral for those loan types.

Getting approved for a secured loan can be easier than getting an unsecured loan because secured loans pose less financial risk for lenders. Since they require collateral, they typically have more competitive interest rates than unsecured loans.

How do unsecured loans work?

Unsecured loans can be either for no-collateral installment loans, such as unsecured personal loans, or unsecured revolving lines of credit, such as unsecured credit cards. When you submit an application, the lender will check your creditworthiness and consider factors such as your income, savings and debt to see if you qualify.

Although 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 cause your credit scores to drop

Who should get an unsecured loan?

Whether an unsecured loan is the right option depends on the borrower’s financial situation and the purpose for the funds. Borrowers who need money but aren’t comfortable pledging collateral to secure a loan can consider an unsecured loan when:

• Planning for a large purchase. Taking on debt can put a strain on your finances, but if you need funds for a big upcoming expense, an unsecured loan can help.
• They have good credit. Having a high credit score unlocks more favorable unsecured loan terms and interest rates.
• They have reliable income. Although collateral isn’t needed for an unsecured loan, you’ll need steady income to repay the debt and avoid defaulting on the loan. Unpaid secured loans can negatively affect your credit.
• Consolidating debt. Unsecured loans are useful as debt consolidation tools that can make debt repayment simpler. This strategy can also help borrowers save money if they qualify for lower interest rates.

Qualifications for an unsecured loan

To limit their risk, lenders want to be reasonably sure you can repay the loan. Lenders measure 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 loan terms according to your answers):

Your credit

Lenders check your credit reports to see how you’ve managed loans and credit cards in the past. Generally, they look for a 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.

Your income

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 stable, sufficient income, such as a current pay stub.

Your debt-to-income ratio

To calculate your debt-to-income ratio (DTI), add all your monthly debt payments and divide that total by your gross monthly income. For example, if you have $500 worth of existing debt payments and $2,000 in gross income each month, then your DTI is $500 / $2,000 = 0.25 or 25 percent.

Lenders use this number to measure your ability to repay a loan. The lower the ratio, the better. Every lender will have a different requirement for your DTI, but the maximum is usually no higher than 43 percent.

Assets

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.

How to apply for an unsecured loan

If an unsecured loan is right for you, applying takes several simple steps:

1. Determine how much you need. Only borrow what you need, even if the lender approves you for a higher amount.
2. Research top lenders. You can find unsecured loans through national and local banks, credit unions and online lenders.
3. Compare unsecured loan offers. Some lenders offer prequalification so you can see which loans you might qualify for before you apply. Look at each lender’s interest rates, fees, loan terms and amounts and special features.
4. Submit an application. After checking preliminary offers and selecting your preferred lender, complete a formal loan application. This can be done online or in person through most lenders.
5. Provide documentation. If the lender asks for additional documentation, submit it in a timely manner. This might come up if you don’t have strong credit, for example.
6. Accept loan funds. If you’re approved, the lender will tell you how you’ll receive the loan funds. If it’s an installment loan, you’ll receive the money as a lump sum. For revolving loans, such as a credit card, the lender will issue you a credit card to draw funds from the account as needed.

Whenever you take out an unsecured loan, make sure you repay it on time to avoid damaging your credit score.

The bottom line

The main advantage of an unsecured loan is that you don’t have to pledge collateral. But if you default on the loan, you could still face some serious consequences, like major damage to your credit. Plus, a lender could take you to court to garnish your wages.

Taking out an unsecured loan can be a good idea if you have a plan to repay the debt. If you decide that an unsecured loan is right for you, compare rates, terms, fees and from as many lenders as possible before applying.

Learn more:

• How to get a personal loan in 8 steps
• Secured vs. unsecured personal loans: What you need to know
• What is a personal loan?