An unsecured loan, such as credit cards, personal loans or student loans, has no security asset attached to it - home, vehicle, etc. Simply put, no collateral is needed to obtain one. What is an unsecured loan, how do they work, and how can you apply for one?
An unsecured loan, also called a signature loan, needs only a signature for you to attain one if the borrowing requirements from the lender are met. Due to the risk involved for the lender (with no collateral), they can charge higher interest rates and demand a borrower have good or excellent credit. When a borrower quits making payments, defaulting on the loan, the lender has no collateral to recover the debt.
For instance, a borrower loses their job and is unable to pay back an unsecured personal loan and credit card. The accounts are defaulted on, and the borrower' s credit is negatively impacted. The lenders may decide to shoulder the monetary loss or ask the court to issue a judgment to attain payment. What they cannot do is seize a borrower' s assets until going through the courts.
Difference Between Unsecured and Secured Loans
The most significant difference is the need for collateral when it comes to the differences between a secured and unsecured loan. Secured loans need collateral, while unsecured loans do not. If a lender agrees to a secured loan, the borrower must provide them with an asset. No asset means no loan.
Secured loans include mortgages, home equity lines of credit, auto loans and some kind of personal loans. Unsecured loans are unusual with car loans and mortgages since the asset is tied to the loan itself.
It' s easier to attain a secured loan than an unsecured one because lenders don' t have near the risk involved. Plus, the interest rates tend to be much more competitive.
The Workings Of An Unsecured Loan
Unsecured loans are non-collateral, installment loans or unsecured revolving lines of credit. If you have a credit card or student loan, you likely have an unsecured loan. Upon submitting your application, the lender pulls your credit report and score to determine creditworthiness. They will look at factors like income, debt and savings.
If you fail to repay on your "promise to pay" account, the lender has some recourse to attain payment:
- Hire a collection agency to attain payment
- Have the court issue a wage garnishment order
- Report late payments to credit bureaus
- Every one of these actions will lead to a drop in your credit score
What Are The Benefits Of An Unsecured Loan?
- No need for collateral
- Quick access to money
- No loss of assets
- Fewer restrictions on borrowing
- Competitive rates for people with good and excellent credit
What Are The Disadvantages Of Unsecured Loans?
- Possible loss of assets
- Lower borrowing limits and higher interest rates for people with poor or bad credit
- Approval is harder
Should You Attain An Unsecured Loan?
When is an unsecured loan the right thing for you? It depends on two things:
- Your financial status
- What the money will be used for
If you' re uncomfortable putting up collateral to attain a loan, consider the following when:
- You' re buying something expensive – A loan may be necessary if you' re buying something expensive, such as a car, home or other expense.
- You have good or excellent credit – A high credit score translates to better interest rates and loan terms.
- You have reliable income – While collateral is not a necessity for unsecured loans, a steady income is a must to pay back a loan to avoid defaulting on it. Defaulting on unsecured loans hurts your credit.
- Consolidating multiple debts – Unsecured loans can make paying back multiple debts easier to manage. It' s a noteworthy strategy for people who can qualify for the lower interest rates.
4 Factors Lenders Use To Grant Unsecured Loans
Lenders want to lower their risk, so they will measure your creditworthiness to determine if you can pay back the loan. When applying for an unsecured loan, they will look at four particular factors that affect whether or not you get a loan and what the loan terms will be.
Lenders will pull your credit report and score, allowing them to see how you' ve managed your credit in the past. What are they looking for?
- Your past credit history
- Current credit card balances
- Mix of account types
- Timely payments
- Credit scores (This is comprised of the information attained in the credit report)
Consumers who have a 700 or higher credit score tend to qualify for more favorable interest rates.
A lender wants to know that you have sufficient income to meet all your debts, including any new ones. They may ask for proof of income like a current paycheck stub.
How do you get your debt-to-income ratio? Add all the monthly debt payments you have and divide it by the gross monthly income. If you have a gross income of $2,000 with a $500 debt payment, your DTI is 25%.
Lenders will use the number to determine your loan repayment feasibility - the lower your ratio, the better the chances of being approved. The DTI required is usually less than 43%, but all lenders are different, and requirements will vary.
Lenders will look at your savings to determine that you have the ability to repay a loan in case of an emergency.
6 Steps To Applying For Your Unsecured Loan
Applying for an unsecured loan is easy and is done in six steps:
- Determine how much money you need, borrowing just that amount even if you' re approved for a higher loan amount.
- Do research into each lender, including local bankers, online lenders, credit unions, etc.
- Make sure to compare the different loan offers, using the prequalification tool to determine which offers would be better for you. Review the loan terms, interest rates, amounts, special features and fees.
- Complete an application with your preferred lender, either in person or online.
- If a lender requires more information before approving or denying your loan, submit this information quickly. This is generally an issue with people with less than ideal credit.
- Upon approval, your lender will send you information on how the funds will be sent to you. If you have an installment loan, you' ll get a lump sum loan. With revolving lines of credit (think credit card), you' ll be granted an amount to spend up to.
The most important thing to remember is to pay back the loan on time, so your credit score isn' t negatively impacted.