Taking out an unsecured loan may be a good option when you need to borrow money. Unsecured loans are loans and credit cards that aren’t backed by an asset, or collateral. Qualification requirements may be strict, and the loan may come with higher interest rates than secured loans.
But unsecured loans offer convenience and the ability to borrow money without putting up collateral. Here’s what to know before applying for an unsecured loan.
What Is an Unsecured Loan?
An unsecured loan is a loan supported by your creditworthiness rather than collateral, such as property or a cash deposit. Unsecured loans are sometimes known as signature or good faith loans because only your signature confirms your promise to repay the loan. Credit cards, personal loans and student loans are all examples of unsecured loans.
Types of Unsecured Loans
You have many options when you need an unsecured loan, and the one you choose depends mostly on how you’re planning to use the funds.
People often take out unsecured personal loans when they need flexibility. This type of loan can range anywhere from a few hundred dollars to $100,000 and can be used for almost any expense.
Student loans are slightly more restrictive because they can only be used for education expenses, such as tuition and textbooks. The federal government funds federal student loans, while private student loans come from banks, credit unions and online lenders. Both types of student loans are unsecured.
A credit card provides access to revolving credit, which means you can spend up to your credit limit, pay it back and borrow again as needed. Card issuers may offer secured credit cards backed by a cash deposit, which serves as collateral in case of default. But many credit cards are unsecured.
[Read: Best Personal Loans.]
How Unsecured Loans Work
Each type of unsecured loan provides a way for you to borrow money that you’ll repay over time, but they all work in different ways.
Unsecured personal loans: You can generally use unsecured personal loans for almost anything, but check the terms to make sure your expenses are covered. Some lenders won’t let you apply the funds to business expenses and investments, for instance. And you can’t use a personal loan for the down payment on a conventional or FHA mortgage loan.
If you qualify for an unsecured personal loan, you will typically receive the funds as a lump sum upfront and make installment payments over a term of two to seven years. Most personal loans have fixed interest rates, providing predictable payments for the life of the loan.
Student loans: These are similar to personal loans in that the lender issues a lump sum and you pay installments over time. But student loans come with limits to how much you can borrow. Typically, student loan funds are sent directly to your school to cover tuition and fees, and you will receive any leftover money.
When it comes to terms, federal student loans come with fixed interest rates, while private student loans often have fixed- and variable-rate options. Many offer a special feature that allows you to defer payments while you’re enrolled in school and then repay the balance over 10 years or more.
Credit cards: You get access to a line of credit that you can borrow against and repay as often as needed without having to apply for more credit. If you pay off your balance by the due date each billing cycle, you can avoid interest charges.
[Read: Best Private Student Loans.]
Unsecured vs. Secured Loans
The key difference between unsecured and secured loans is whether you need to pledge collateral to get the loan.
A secured loan is backed by collateral. A mortgage is secured by your home, for example, while a secured credit card requires a cash deposit to open the account.
Your lender puts a lien on the asset that acts as collateral, which gives the lender a legal right to your asset to satisfy a debt. If you fail to pay your loan, the lender may seize the asset to recoup its losses.
Unsecured loans don’t require collateral to qualify, and “come with flexibility and freedom to be used for whatever purpose the borrower chooses,” says Tara Alderete, director of enterprise learning at Money Management International, a nonprofit credit counseling organization.
But if you stop making payments, the lender has recourse. “Default will likely result in collection efforts, which, if not successful, could lead to negative credit reporting — and even legal action or wage garnishment in some cases,” Alderete says.
Lenders know that recouping their money after a borrower defaults on an unsecured loan can be time-consuming and difficult. That’s why they take steps to reduce risk, such as setting stricter eligibility requirements than with secured loans.
Borrowers also usually pay higher interest rates because “the lender has fewer alternatives for recovering loan proceeds,” says Alesha Isaacs, certified financial planner and financial coach at Financial Finesse, a provider of workplace financial education programs.
Pros and Cons of Unsecured Loans
— No collateral requirement. You don’t need to hand over a deposit or pledge a valuable asset to qualify.
— Quick application and disbursement. The application may be completed in a few minutes, and you may be able to find out whether you qualify on the same day you apply. You could receive your funds soon after.
— Flexible use. Unsecured personal loans and credit cards can be used for almost any purpose.
— Higher interest rates than secured loans. That’s because lenders take on more risk with these products.
— Stricter qualification requirements. You’ll typically need strong credit and income to qualify, especially if you want a low interest rate.
— Smaller loan amounts. Except for student loans, unsecured loans usually come in smaller amounts.
Qualifying for an Unsecured Loan
To qualify for an unsecured loan or credit card, lenders will usually check:
Credit history. Lenders pull your credit reports to review details such as the type of accounts you have, the length of time you’ve been using credit, and your payment history. “You’ll likely need an established positive credit history that includes a record of consistent on-time payments,” says Alderete, and “a mix of different types of credit.”
Credit score. You generally need a strong credit score. “A lower credit score may be approved but with less favorable rates and a reduced borrowing limit,” Isaacs says.
Debt-to-income ratio. Your debt-to-income, or DTI, ratio shows lenders what percentage of your gross monthly income — your earnings before deductions — goes toward credit card or loan payments. Lenders may set a maximum DTI ratio as part of their eligibility requirements. They want to make sure you have enough room in your budget to make payments on the new loan or line of credit you take out.
Income. Lenders also want to know you have the money to repay what you’ve borrowed. “The lender will likely look for regular income,” Alderete says. You may have to earn a minimum amount to qualify for the loan.
[Read: Best Low-Interest Personal Loans]
Applying for an Unsecured Loan
You’ve done your homework — you’ve carefully considered how much to borrow and researched top lenders — and you’re ready to apply for an unsecured loan. Here’s the general process you can expect.
1. Get prequalified. Lenders will often allow you to prequalify with a soft inquiry to check your loan eligibility and estimate terms without hurting your credit. You can do this online, by phone or in person. Then you can compare offers, including loan amounts, repayment terms, interest rates and fees, to find the best deal for your credit situation.
You can also prequalify for credit cards without a hit to your credit. But you typically won’t receive your credit limit and interest rate until the application is approved.
2. Apply. Once you choose a lender, you are ready to complete your loan application and provide any necessary documents. Many lenders use a completely digital process, though you may be able to complete the application in person or over the phone.
3. Wait for a decision. The lending decision usually takes about a day once you apply and provide documents.
4. Receive your money or access your line of credit. The lender will tell you how you will receive the funds if your loan is approved. You may receive one lump sum in your bank account, for example, or the lender may pay your creditors if you’re consolidating debt.
Interest starts accruing on the loan once you receive your funds, and you’ll usually have to make the first payment within 30 days. With a credit card, you will be given a minimum monthly payment to make on your balance.
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