Written by: Eric Bank
Edited by: Austin Lang
Reviewed by: Jon McDonald
Funny thing — many people are insecure, and many loans are unsecured. What do they have in common besides “n-s-e-c-u-r-e?” Well, after pondering it a while, I figured it out: both involve anxiety.
That’s pretty evident for insecure people. For loans, the anxious party is the lender since it lends money without requiring collateral. The lender is out on a tightrope with no net. I know that would make me anxious!
Unsecured loans are based on the borrower’s credit scores and income, not collateral.
I’m going to look at unsecured loans from all angles: how they work, how to get them, and how they compare to their secured cousins (offered by calm, mellow lenders). After reading the article, you’ll be secure in your knowledge of the topic.
How Unsecured Loans Work
You should know how unsecured loans operate before hitching yourself to one. Understanding what these loans look like should help you decide whether they’re the best product for you.
No Collateral Requirement
Unlike secured loans, unsecured loans do not need you to put up your house, truck, or a cash deposit to borrow money. Instead, lenders will consider only your credit profile and income. That profile consists of your credit history and score. The better they are, the easier it will be to lock down a loan with good terms.
Now, what’s the lender giving up by not asking for collateral? Well, it can’t go out and grab your property if you can’t pay.
That’s like lending someone your car with no assurance you’ll ever get it back. Of course, the lender can take you to court if you don’t cough up the money you owe, but that’s an expensive and tedious process for both parties.
Typical Interest Rates and Terms
Since the lender is left with only the trust that you’ll make good on your payments, unsecured loans tend to carry higher interest rates than their secured cousins. That’s the price good borrowers must pay to compensate the lender for people who skip out on payments.
The terms can stretch or shrink depending on how the lender has fared in the past. Naturally, your terms will be better if you have good credit and a solid income. Conversely, you’ll have a real challenge if your finances look like they’re one step away from the zombie apocalypse.
If you have good credit and a solid income, you should get better terms and interest rates on unsecured loans.
Providers of unsecured loans enjoy collecting fees early and often to reduce their risk exposure. They tack extra costs onto your loan to help cover their backsides, kind of like spreading sawdust on a pub’s slippery floor. It’s a little insurance against things skidding out of control.
Common Types of Unsecured Loans
There’s a wide variety of unsecured loans out there, each one doing a different job but working under the same premises.
- Personal loans: Personal loans are your Swiss Army knife. Borrow what you need to fix the roof, pay bills, consolidate your debts, or whatever else is on your mind. No questions asked, as long as you pay it back.
- Credit cards: These are versatile tools offering unsecured credit. You can swipe, tap, or insert them here and there for small expenses or bigger buys, but be careful — leave that balance hanging too long, and you’ll pay more interest than you may have bargained for.
- Student loans: Then there are student loans, serving as long-term albatrosses weighing down your budget. They help you plow through school, but after you’re done, you’ll be paying them back for a long time.
Since all these loans are unsecured, you won’t lose any collateral if you don’t pay it back on time.
Secured vs. Unsecured Loans
It’s important to know the difference between a secured and an unsecured loan when you intend to borrow. Choosing the wrong one can put you in a pickle later on. A secured loan involves collateral — something valuable, like your house, car, or land — as security for payment. If you fail to pay, then you may have to kiss your property goodbye.
On the flip side of the coin, an unsecured loan does not ask for collateral, but you need a good credit score and a steady income to get one with attractive terms.
Risks for the Borrower
With a secured loan, you’re putting your assets on the line. If, for some reason, you are unable to make the payments, then the lender can take your house, car, or whatever it was you pledged. It’s like playing poker with the keys to your vehicle in the pot — if you lose, it’s gone.
With unsecured loans, borrowers don’t directly risk losing their property to lenders.
Unsecured loans don’t present that sort of risk, as you aren’t pledging a security interest in anything. In this way, when things go awry, you are not at risk of losing stuff. But you can’t get too cozy either, because if you go into default, your credit rating will plunge, and you may find yourself looking for a lawyer pronto.
The Approval Process
In the case of unsecured loans, approval generally depends on your creditworthiness. What lenders are looking for is a credit history showing that you pay your debts on time and can manage the new loan’s payments, given your income level.
With secured loans, though, it’s more about the value of what you’re putting up as collateral. Whether it’s your land or that new fancy truck of yours, it’s about the money the lender can squeeze out of the asset if it has to seize and sell it. If it’s worth enough, you may be able to get a bigger loan, even when your credit is not that good.
Limits on Loan Amounts
Unsecured loans are often smaller sums because the lender’s taking a bigger gamble. Without any collateral, they’re essentially betting on your word (and your credit score). In that case, they’ll more than likely keep the size of the loan on the smaller side to protect themselves.
It’s like borrowing from a friend: It’s easier to borrow a bike than a car.
Secured loans may allow you to borrow more money. After all, you are putting up collateral. With your skin in the game, the lender will feel more secure handing out the loan funds. You are more likely to get what you need because you have much more at stake.
I’ll summarize how these two loan types perform against each other in a head-to-head matchup. It’s all in the following table:
| ASPECT | SECURED LOANS | UNSECURED LOANS |
|---|---|---|
| Collateral Requirement | Requires collateral | No collateral needed |
| Loan Amount | Higher loan amounts | Lower loan amounts |
| Bad Credit Approval | Easier with collateral | Harder without collateral |
| Interest Rates | Usually lower | Usually higher |
| Risk to Borrower | You could lose assets | No assets at risk |
| Credit Building | Builds credit | Builds credit if payments are on time |
| Approval Process | Based on asset value | Based on credit score and income |
| Fees | Fewer fees | More fees to cover lender’s risk |
| Application Time | Slower due to asset check | Faster since there is no asset check |
| Flexibility | Usually specific purpose | Can generally be used for various needs |
If your credit is in the dumps, save yourself a lot of hassle and get a low-cost secured loan instead of an unsecured one with high fees. Remember, you get back the title to your collateral when you repay a secured loan, but those unsecured loan fees are gone for good.
How to Qualify for an Unsecured Loan
Before trying to wrangle yourself an unsecured loan, it’s good to know what the lender is looking for. These folks aren’t just tossing money around. They’ve got a list of things they check off before handing over the cash.
The Loan Application Process
It starts with an application you submit on paper or, more likely, online. Lenders want to verify your income and check your credit. After doing so, you get either a thumbs-up or a thumbs-down. It’s just like asking for a seat at a poker game. Either you have the chips to ante up, or you don’t.
Now, applying for a loan means rounding up all your paperwork, including your pay stubs and maybe even your latest two tax returns. It almost invokes the image of gathering kindling for a fire. You’ve got to have enough for the burning to start. Otherwise, your loan just isn’t going to light up.
When lenders check credit, they peek into your credit reports with as much curiosity as your nosy neighbors. They do this to see how reliable you’ve been with credit in the past.
These credit checks are called hard inquiries and can potentially impact your score. Too many credit checks will bruise your score, so be careful about how many times you apply within a short stretch of time.
Credit Score Requirements
Most unsecured lenders want borrowers to have a credit score that’s sitting nice and pretty, somewhere in the good-to-excellent range. You see, these lenders don’t have any collateral to hold on to, so your credit score is one of the few things keeping them from pulling their hair out worrying you’re going to skip town without paying.
However, some lenders will give unsecured loans to people with sorrowful scores, but it’ll cost you. High-risk borrowers get saddled with sky-high interest rates and fees, almost like paying extra tolls on a road no one wants to travel down.
If your credit score isn’t quite up to scratch, try to raise it before applying.
- Pay off any outstanding debts
- Fix errors on your credit report
- Never miss a payment due date
It’s like repairing a leaky roof — patch it up now, and you’ll save yourself a flood of money later.
Working on your credit takes time, but if you are patient and steady, you might be able to get that score up to a place where lenders won’t think twice about giving you a “Yes!”
Income and Debt-to-Income Ratio
The debt-to-income (DTI) ratio is how much of your monthly income goes to paying off debt.
With an unsecured loan, you have to be able to prove not only that you have a regular income but also that your DTI ratio is within reason. The lender has to feel comfortable that you are pulling in enough cash every month so that the obligation will not make you strain like some rusty clunker trying to make it up a hill.
The best ways to lower your DTI ratio is to pay off debts and/or increase your income.
Different lenders have different acceptable DTI ratios. Some might be OK with higher ratios for personal loans, while others are stingier when it comes to credit cards or student loans.
Advantages of Unsecured Loans
Unsecured loans might just be the ticket if you’re looking for a way to get your hands on some extra funds without putting your vehicle or house on the line. These loans boast a few advantages that make them mighty appealing to people who do not want to risk their prized possessions.
- Limited Asset Risk: You won’t need to be concerned that a lender may arrive at your home with a tow truck to haul away your car, seize your house, or kidnap your purebred Cocker Spaniel if you are unable to pay. With no collateral on the line, your stuff stays yours even if you can’t repay your loan. That is, unless the lender hauls you into court and wins a judgment against you. Then, all bets are off, and you could be hung out to dry in the wind.
- Quick Application Process: Unsecured loans do not require the lender to take stock of your property, so the process is generally pretty fast. Apart from waiting for confirmation about the items in your loan application, you should be good to go. The speedy procedure means that you can attend to your cash needs without a lot of foot-dragging and lollygagging.
- Flexible Use: Most times, an unsecured loan can be used for practically anything under the sun, including house fix-up work, unexpected bills, or even starting a little business. In other words, there are usually no restrictions. It’s like being handed a bundle of cash with no strings attached to how you spend it. Student loans are the exception; they are earmarked for tuition and educational expenses. You can’t grab the money and run to Vegas for a wild weekend.
The general flexibility of unsecured loans leaves you free to decide what is most important to you without bothering about the lender’s permission.
Drawbacks of Unsecured Loans
Before you go jumping headfirst into one of these loans, you need to be aware of the pitfalls, too.
The honest-to-goodness truth is, as with any deal, there are a few thorns mixed in with the roses, and if you’re not watching, they can prick you where it really hurts.
- Potential Higher Interest Rates: Because you’re not putting up any collateral, the lender’s taking on more risk. You can expect to pay more interest — that’s the toll for getting cash without putting up something in return. The interest can rack up a lot more quickly than you might think it would, so make sure you can handle the load before you sign up.
- Possible Limited Loan Amounts: Unsecured loans are often smaller than the secured type. If you aim to finance a massive project, you might be disappointed if the lender is not able to give you the amount you’re counting on. It’s like trying to deliver a house’s worth of lumber with a simple pickup truck — you might have to scale down the project.
- More Application Scrutiny: When it comes to unsecured loans, lenders are pickier. You will have to exhibit a higher credit score and a rock-solid income to pass muster. You must prove yourself to be a steady hand before anyone is willing to give you the reins. If you don’t measure up, you may have to get out and walk.
In the final analysis, unsecured loans can be a vastly useful tool, but you’ve got to know what you are getting yourself into. Weigh the pros and cons carefully, and don’t tie yourself to a commitment unless you’re certain it will get you where you want to go without any hiccups along the way.
Unsecured Loans Give Creditworthy Borrowers Flexibility
Freedom is a virtue that I treasure dearly. Unsecured loans, for the most part, leave you free to spend the proceeds in any way you like.
I’ve exercised my freedom to use unsecured loans however I see fit several times over the course of my life. If you have the right financial profile, you can too.
