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What is an unsecured loan?
An unsecured loan is a type of loan that isn’t backed by collateral, which is an asset (or a collection of assets) that your lender can seize if you fail to pay back your debts on time, known as defaulting.
If you default on a collateral-backed loan (known as a secured loan), your lender can immediately take your collateral as compensation. By contrast, if you default on an unsecured loan, none of your assets will immediately be at risk. It’s still possible for your lender to seize your property if they take you to court and win a judgment against you, but this is more difficult than simply claiming your collateral.
Common examples of unsecured loans include student loans and unsecured personal loans, both of which are installment loans. There are also unsecured credit cards, which are a type of revolving credit account.
How do unsecured loans work?
When you apply for an unsecured loan, your prospective lender will check your credit and consider other factors like your income to evaluate your risk as a borrower and decide whether to approve or deny your application.
Your loan’s annual percentage rate (APR) is the yearly interest rate that you’ll pay. Depending on the type of loan you’re getting, your lender might charge you additional fees for processing it. Your APR includes these added costs.
Your lender will report your account balance to the nationwide credit bureaus (Equifax, Experian, and TransUnion) every 30–45 days. 1 If you pay your bills on time, your credit score will increase. However, if you miss a payment, you’ll get a derogatory mark on your credit report and your credit score will drop.
Types of unsecured loans
The following are common examples of unsecured loans:
- Unsecured personal loans
- Student loans
- Personal lines of credit
Secured vs. unsecured loans: what’s the difference?
As mentioned, unlike unsecured loans, secured loans require some form of collateral. This can be a monetary deposit or a valuable asset (such as a car or house).
When you take out a secured loan, you place a “lien” on your collateral, which grants your lender the legal right to seize (or repossess) it if you fail to pay them back as agreed.
The following are all types of secured loans:
- Home equity line of credit
- Home equity loan
- Car loan
- Pawnshop loan
- Secured line of credit
- Life insurance loan
- Title loan
Unsecured loans are generally much harder to qualify for than secured loans because they put lenders at higher risk. They also often come with higher interest rates than secured loans do. 2
Advantages and disadvantages of unsecured loans
Unsecured loans have a lot of advantages, but they also have some drawbacks.
Advantages of unsecured loans
Unsecured loans have two main benefits:
- Short application process: You don’t need to get any of your assets appraised to get an unsecured loan, so you can get your funds more quickly than with some types of secured loans. If you need quick cash, that’s a significant draw.
- No collateral: If you default on your payments, your lender usually can’t repossess your car or foreclose on your home (without taking you to court).
Disadvantages of unsecured loans
Unsecured loans also have three significant drawbacks:
- High-interest rates: Although the lack of collateral simplifies the application process for unsecured loans, it also means that lenders will charge higher interest rates to compensate for the increased risk they’re taking on when they lend you money.
- Qualifying is difficult: Lenders often have higher credit score requirements for unsecured loans because they want reassurance that you’ll repay your debt. If you have poor credit, you usually won’t be able to qualify.
- You can still lose your assets: If your lender gets a court judgment against you because you defaulted on your unsecured debt, they can garnish your wages (meaning they can take a portion of your salary as payment). 3 They can also take your property or even your home if the judge rules that a lien should be put on your property. 4
How to get an unsecured loan in 5 steps
To get an unsecured loan, follow these five steps:
1. Make sure you’re qualified
Lenders are selective about which consumers they’ll offer unsecured loans to. If you can’t provide them with good reason to think you’ll make all your payments on time, they won’t want to issue you a loan.
When assessing your eligibility, lenders generally consider the following factors:
- Credit score: Your credit score is a numerical representation of your creditworthiness. Virtually all lenders use it to determine how likely you are to pay your bills on time. One of the main benefits of having good credit is that it’s easier to qualify for unsecured loans and loans with lower interest rates.
- Income: It’s generally easier to meet a lender’s requirements if you have a good income because there’s less risk that you’ll default on payments. Prospective lenders usually ask for proof of income (i.e., pay stubs) when deciding whether to offer you a loan.
- Debt-to-income ratio: Your debt-to-income ratio (DTI) is the percentage of your monthly income that goes toward repaying your debts. For example, if you earn $2,000 per month and spend $600 on paying your existing debts, your DTI is 30% ($600 divided by $2,000). Having a lower DTI ratio makes it easier to qualify for an uncollateralized loan.
- Assets: Some lenders also inquire about your assets to make sure that you have emergency savings. If you do, then they’ll see you as less likely to fall behind on your loan payments.
2. Research your potential lenders
Lender requirements tend to vary, so it’s important to do your research before applying.
Start your search for an unsecured loan by checking out what options are available to you from the following lenders:
- Online lenders: Many online lenders offer loan pre-qualification services that you can use to check your eligibility for a loan without triggering a hard inquiry (which will hurt your credit score).
- Banks: If you already have a bank account, contact your bank to find out what unsecured loans they offer.
- Credit unions: A credit union is a type of nonprofit financial institution that’s owned by its members. You usually need to become a member of a credit union (and pay a small fee) to get a loan. On average, credit unions tend to offer slightly lower interest rates than banks do for loans with no collateral. 5
3. Shop around for the best offer
When looking at your loan options, carefully consider these four factors to ensure that you’re getting the best deal on your unsecured loan:
- Annual percentage rate (APR): Look for the loan with the lowest APR; this will probably be your best deal.
- Repayment term: If you get a long-term loan, your payments will be spread out over a longer period of time, meaning each individual monthly payment will be lower than with an equally sized shorter-term loan. However, you’ll pay more money in the long run because you’ll be paying interest for a longer period. Look for a loan term that suits your financial situation.
- Loan amount: Get a loan that’s sufficient to pay for your expenses, whatever they are. Also consider how much money lenders are willing to let you borrow. If you have poor credit, lenders might only be willing to offer you small loans.
- Special features and discounts: Find out if prospective lenders offer any special features or discounts, like a discount for using autopay or an introductory 0% APR period.
4. Submit the application form
Once you’ve chosen a lender, submit a formal application. You can do this online or in person. Make sure to include any documents that your lender requests (like bank statements or your ID).
5. Accept the loan funds
If the lender approves your loan application, you’ll usually receive the funds directly into your checking account.
Once you’ve accepted an unsecured loan, make sure to always pay your bills on time to avoid incurring late payments on your credit report, which can seriously hurt your credit. As long as you take your obligations seriously, you’ll actually build credit over time by demonstrating that you can responsibly manage your debts.
If you didn’t previously have any installment loans, taking out the loan will also boost your credit mix, which will raise your credit score.