Unsecured loans are loans provided without something serving as collateral to secure the loan. Some people call them "signature loans," where a signature and your "good name" are all required to obtain the loan. The better you understand unsecured loans and how they work, the wiser will be the choices you make about whether an unsecured loan is right for you.
How Does an Unsecured Loan Work?
There's no collateral necessary with an unsecured loan. That means lenders look more carefully at lending factors such as credit utilization ratios, credit scores, salary, and debt-to-income before extending credit.
Once lenders have decided to extend credit, you may find that interest rates and terms for the loan are less favorable for unsecured loans than for secured debt. One good thing about an unsecured loan is that once you have the funds, you can use them for practically anything, as the debt isn't associated with a single purchase or big-ticket item. The one exception is education loans that restrict the funds' use.
People consider unsecured loans for many reasons. In addition to education loans, debt consolidation loans are among the most popular. People use these loans to pay off credit card debt that often has a considerably higher interest rate for a lower interest rate saving massive piles of money. Other people take out personal loans to pay for weddings, to take dream vacations, to make home improvements, and for countless other reasons.
Most credit cards are also unsecured loans. While they constitute revolving credit rather than stable monthly payments for a prescribed amount, they offer revolving credit that can be used, repaid, and used again. Of course, the higher interest rate associated with unsecured credit cards makes them unattractive to many consumers who prefer the lower interest rates that unsecured loans offer.
Benefits
There are many benefits to remember if you're considering an unsecured loan, and the advantages below can make a huge difference for those on the fence between this and other loan types.
- No collateral, which reduces the risks to the borrower.
- Fast access to money when needed (especially compared to secured loans that may take longer to assess and approve collateral).
- Fewer restrictions are associated with the loan and how the money can be used.
- No loss of assets if a borrower defaults.
As you can see, the benefits are attractive for unsecured loans. However, it is essential to explore the downside, so you can choose the best option for your short and long-term financial success.
Drawbacks
The drawbacks of an unsecured loan are straightforward. While they may not appear as painful as the potential drawbacks of many secured loans, they demand attention. These are a few potential downsides to consider.
- You may have lower borrowing limits than with a secured loan.
- Your interest rates are likely higher than with a secured loan.
- Approval is more complex than a secured loan (standards for credit score, credit utilization, and debt-to-income, for instance, are higher with an unsecured loan).
Most consumers need to possess outstanding credit and a reliable income to obtain unsecured loans. While you do not have to use collateral to secure an unsecured loan, failure to repay the loan has long-lasting and far-reaching consequences. Use care when taking out an unsecured loan so that it doesn't stretch your resources uncomfortably, placing your ability to repay the debt at risk.
Using Unsecured Loans Responsibly
Using unsecured loans responsibly involves having a plan from the start. Your goal should include maintaining good credit to obtain the loan and a method for using the money borrowed and repaying the loan on time. Many people use unsecured loans to consolidate existing debt. This strategy can be effective if your unsecured loan has a lower interest rate than the debt you're paying off and as long as you maintain your commitment to eliminating unnecessary additional debt.
Alternatives to Unsecured Loans
The most notable alternative to an unsecured loan is a secured loan. These loans are a more attractive option for people seeking lower interest rates and higher loan amounts than are typically available through unsecured loans without extraordinary circumstances. However, both unsecured loans and secured loans have their place in a well-rounded financial plan.