An unsecured loan is a loan that's issued without collateral. Borrowers do not need to pledge assets to secure the loan; instead, qualification is hinged solely on their creditworthiness. Unsecured loans are also referred to as "signature loans" since the borrower's signature is the only guarantee they offer to the lender. You sign an agreement that you'll repay, and the lender accepts your signature as a bond.
Unsecured loans typically have higher interest rates than secured loans, and most lenders do not offer large loan amounts. However, applicants with super-prime credit scores (FICO of 740 and above) and significantly high incomes may be able to get approved for loans exceeding $50,000. The higher your credit score, the better the terms you're offered.
Common Types of Unsecured Loans
Unsecured loans are the fastest-growing consumer lending class in the US, and according to this TransUnion report, the sector grew by over 98 percent between 2015 and 2019. Here are the most common types of unsecured loans:
Personal loans are generally unsecured, and they are provided by banks, credit unions, and online lenders. Borrowers can use the funds as they want, as long as they pay back based on the pre-established schedule.
Credit cards provide a revolving line of credit, and this type of loan is typically taken out without collateral. Even though the loan amount is not provided as a lump sum, cardholders have access to funds whenever they need it, provided they pay off their balances on time.
Student loans that are financed through the US Department of Education and some private student loans are unsecured.
Advantages and Disadvantages of Unsecured Loans
If you are thinking of applying for an unsecured loan, here are some benefits you stand to enjoy along with drawbacks to expect:
Advantages of Unsecured Loans
The approval process is relatively short
While it is often easier to get approval for a secured loan, it takes a shorter time to apply for (and get) an unsecured loan. This is because the latter does not require you to submit documentation on the assets being proffered as collateral. You don't need to get your home appraised or your property inspected. This saves a lot of time and money.
With unsecured loans, there are strict income and credit score requirements. Some online lenders may approve your loan within minutes and credit you in two or three days if you meet the requirements. Banks and credit unions will take more time, but not as much they'd take with a secured loan.
They often have fixed interest rates
Some unsecured loans have fixed interest rates. This means borrowers are not affected by changes in market rates. Additionally, you can predict monthly payment amounts from the start, making the loan easier to budget for.
Credit cards are an exception, as many of them charge adjustable interest rates. However, you can avoid paying interest entirely if you pay off your balance before the monthly deadline.
The borrower assumes less risk
If you put your home, car, or property up as collateral, defaulting on a secured loan may lead to the loss of the asset. Conversely, if you default on an unsecured loan, your assets are safe unless the lender gets a court order to seize them. Before that happens, however, you will be given several opportunities to pay back.
The disadvantages of unsecured loans
Loan amounts are smaller
Since the lender assumes significant risk, unsecured loans typically have smaller principals than secured loans. Most lenders cap their loans at $50,000, and only borrowers with super-prime credit that earn income in the top 5% may access bigger loans. In comparison, secured loans provide borrowers with loans of up to 90% of the collateral asset's value.
Interest rates are relatively higher
On average, you may be charged between 5 to 36 percent for an unsecured loan, depending on your creditworthiness. Online lenders often have the lowest rates, and community banks and credit unions offer lower rates than national banks.
Since your asset serves as collateral, secured loans charge lower interest rates. The average interest rate for a car loan is 5.01% (for FICO scores above 700). For a 15-year fixed mortgage, lenders charge an average interest rate of 3.18%.
They have short repayment duration
Unsecured loans generally have a repayment duration of between one to five years. Some lenders may give you up to 10 years, but you probably won't find any signature loans with terms exceeding ten years. In contrast, borrowers may get longer terms (25 years or more) with secured loans.
Qualifying for an Unsecured Loan
To qualify for an unsecured loan, you need the following:
A good credit score: To mitigate their risk, lenders only offer unsecured loans to creditworthy borrowers. The most reliable metric to measure creditworthiness is your credit score, and the higher it is, the better your chances of qualifying for a loan.
High and consistent income: Lenders generally request evidence of a stable income. You will be asked to submit your pay stubs, bank statements, and tax returns. Additionally, lenders prefer borrowers with a low debt-to-income ratio, so any running loans you have will factor into the decision to approve your request.
A co-signer: If your credit score and income level are not high enough, some lenders allow borrowers to bring on a co-signer with more creditworthiness. If you default on the loan, however, they will be held responsible for your outstanding debt.
If you need a quick injection of funds and don't want to put your assets up as collateral, look into getting an unsecured loan. They provide a near-immediate reprieve, and you can work on paying off the debt over time. Do not apply for a loan amount you'll struggle to repay. Look out for interest rates; the lower, the better. Online lenders offer the lowest rates; shop around till you find one that gives you excellent terms. Also, watch out for extra charges (like processing or origination fees) that may inflate the true cost of the loan.
Finally, remember to pay off the loan on time. This increases your credit score, meaning higher limits, lower interest rates, and a better chance of approval when you apply for loans in the future.