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What is an Unsecured Loan?
Main Street borrowers and creditors, especially those financial consumers who might be just starting out, should have a solid understanding on unsecured loans, and how they compare to secured loans.
Why? Because it’s good personal financial business. Knowing where you stand as an unsecured loan consumer gives you the information you need to make smart financial decisions.
Uncle Sam does a good job of defining unsecured and secured loans and credit – this from ConsumerFinance.gov
Secured loans require the borrower to provide collateral (something of value like a car, a boat, a home, etc.) that
the bank or lending institution can take if the borrower can’t pay back the loan.
Unsecured loans require no collateral, so the bank or lending institution is trusting that these borrowers will pay
them back. This trust is based on their creditworthiness — what borrowers have done in the past.
Let’s dig deeper on unsecured loans and answer a few key questions on the topic.
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Why would a borrower prefer an unsecured loan?
The concept of not having to produce collateral to secure a loan is a big reason why borrowers appreciate unsecured loans.
“Unsecured loans are appealing to those who prefer not to pledge collateral as part of their loan agreement,” said Lisa Torelli-Sauer, editor at Sensible Digs, a household finance advisory platform.
“If the borrower defaults on the loan, their credit will be damaged, but the lender will not attempt to collect collateral, as is the case with secured loans.”
Additionally, borrowers can use unsecured loan funds for whatever purpose they want, such as debt consolidation, medical bills, or even vacation expenses. “Plus, unsecured loans requiring no collateral funds are usually available quickly,” said John Davis, founder of ScoreSense, a Dallas, Tx.-based credit score services company.
The fast underwriting process and reduced risk of affecting personal assets are also an appealing factor with unsecured loans.
“If you don’t pay back a secured loan like a mortgage or auto loan, the lender has a fairly straightforward means of taking ownership of the house or car,” said Ben Shrauner, a real estate investor and owner of the web site, SellYourKCHouse.com. “In the event you’re unable to pay back an unsecured loan, there are more hurdles the lender must jump through to try and secure payment. The lender would need to use a debt collection agency or sue to have a lien put on your assets.”
“Defaulting on an unsecured loan can have a significant negative impact on your credit, however and hurt your ability to obtain any type of loan in the future,” Shrauner added.
What type of unsecured loans are available to consumers?
Unsecured loans can come in the form of a line of credit or installment loan, such as a personal loan.
“For instance, A line of credit can be used and repaid again and again (similar to a credit card), whereas an installment loan has set payment amounts with a predetermined payoff date,” Torelli-Sauer said. “Unsecured loans are available at most banks and credit unions.”
The most common loan with no collateral is a credit card. “It’s worth noting that interest rates on credit cards can be very high and falling into credit card debt can be a financial disaster waiting to happen,” said Paul Claybrook, a financial specialist and author of the book “The Market Made Easy.” “Additionally, banks offer personal loans with no collateral. Getting a personal loan is as easy as applying.
What are the biggest risks with unsecured loans?
There are several potential downsides to unsecured loans and higher interest rates are among the largest risks. “Even with an excellent credit history, unsecured loans are a bigger risk for lenders, and they offset some of that risk by charging higher interest rates and offering smaller loans when compared to a secured loan,” Shrauner said.
“In that scenario, a person could easily expect for unsecured loan interest rates to be double compared to a secured loan.”
How can borrowers best prepare to land a good unsecured loan?
Your best move is to make yourself the best candidate possible before applying for a unsecured loan. “Do that by boosting your credit score with healthy payment habits, have a relatively low debt income ratio, and show a steady source of income if possible,” Shrauner said. “Research ahead of time, and know what questions you want to ask.”
Lenders will generally ask for proof of income so be prepared with evidence. “They’ll also your credit score to make sure you would not be overextending yourself with the additional loan,” said Davis. “Payment history as a component of a credit score also plays a big part when it comes to unsecured loans.”
“Reducing your overall credit utilization rate to under 30% will allow you to secure better interest rates on the loan,” Davis said.
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Brian O'Connell has been a finance writer at TheStreet, TheBalance, LendingTree, CBS, CNBC, WSJ, US News and others, where he shares his expertise in personal finance, credit and debt. A published author and former trader, his byline has appeared in dozens of top-tier national publications.