What Is an Unsecured Loan?

Unsecured loans are a convenient way to borrow money without using your assets as collateral. They rely on your credit score and financial history to determine eligibility and terms. This guide explains what unsecured loans are, their benefits and drawbacks, and how to qualify for one.

06.03.2023
3476
13 min.

An unsecured loan allows you to borrow based on your credit score, no collateral is required. Offered by banks, credit unions, and online lenders, these loans have less risk of asset loss if payments are missed. But often require good credit and a steady income to qualify. Unsecured loans have fixed terms and can be used for big purchases or debt consolidation.

What Is an Unsecured Loan?

An unsecured loan is a loan that doesn’t require any collateral, meaning you don’t have to put up assets like a house or car to secure the loan. Instead, these loans are approved based on your creditworthiness, income, and ability to pay back the debt. So it’s a good option for those who don’t have any valuable assets to offer but still need access to funds.

Unsecured loan terms can range from one to seven years, depending on the lender and your financial profile. Loan amounts can vary greatly, from $1,000 to $100,000 or more, some lenders may offer more or less. Interest rates on unsecured loans range from 4.99% to 36%, with a 2-year loan in 2024 averaging 12.33% according to the Federal Reserve. The exact rate will depend on your credit score, loan amount, and lender’s policy.

Why Get an Unsecured Loan

  • Debt consolidation. Unsecured loans are used to consolidate multiple high-interest debts, like credit cards, into one loan with a lower interest rate. This makes managing monthly payments easier and can reduce the overall cost of debt. Debt consolidation can also bring financial stability by offering fixed terms. But only works if the new loan has better terms than existing debts, especially when credit scores are higher.

  • Large purchases. Whether it’s for home renovations, buying a car, or even a wedding, unsecured loans can fund big expenses. They have fixed terms and lower interest rates than credit cards, so you can spread the cost over time. But only borrow what you need, and make sure the interest rates are competitive compared to other financing options.

  • Medical expenses. Unforeseen medical bills, especially for treatments not covered by insurance, can add up quickly. Unsecured loans give you quick access to funds so you can handle urgent medical expenses without using high-interest credit cards or draining your savings. These loans can bridge the gap for uncovered medical costs but use them with caution if you already have existing debt.

  • Education. Federal student loans are often the best option for education funding, but unsecured loans can be an alternative for additional education expenses or when federal loans are not enough. These loans can cover tuition, books, and other related costs, especially for students attending private institutions or graduate programs. But federal loans usually have better terms, so unsecured loans should only be considered if other options are not available.

  • Emergencies. Unsecured loans are a practical solution for covering unexpected emergencies like car repairs or urgent travel expenses. These loans give you quick access to funds with manageable terms, more structured than credit cards. But only use it in true emergencies, and don’t borrow more than what you need to avoid adding to your financial stress.

Types of Unsecured Loans

  • Personal loans. Personal loans are used for various purposes, debt consolidation, big purchases, or home improvements. They have fixed loan amounts, interest rates, and repayment terms so they are predictable and easy to manage. Personal loans are best for consolidating multiple debts into one loan. Since they are unsecured, they don’t require collateral but generally require a good credit score and steady income. They have higher borrowing limits than credit cards and lower interest rates than other unsecured options.

  • Student loans. Student loans are designed to cover education costs like tuition, books, and living expenses. Federal student loans have lower interest rates and better terms than private loans. Many student loans also have deferred repayment, so borrowers can start paying after graduation. Federal loans are often the best option for education funding, but private unsecured student loans can be used when federal loans don’t cover all costs. Like other unsecured loans, private student loans are approved based on the borrower’s credit history.

  • Credit cards. Credit cards offer revolving credit, you can buy up to a certain credit limit. They are flexible since you only need to make minimum monthly payments but carrying a balance beyond the due date will result in high interest charges. Credit cards are good for short-term expenses, but have higher interest rates than personal loans. Some credit cards offer rewards like cashback or travel points, so they’re a good option for everyday purchases. However, the convenience can lead to debt accumulation if you don’t pay the balance in full each month.

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Unsecured vs. Secured Loans

  • Unsecured loans. Unsecured loans don’t require any collateral. They are approved based on the borrower’s creditworthiness, meaning approval is based on credit score, income, and financial stability. Because of the higher risk for lenders, unsecured loans have higher interest rates and lower borrowing limits. Examples are personal loans, credit cards, and student loans.

  • Secured loans. Secured loans are backed by collateral - a home, car, or savings account. This reduces the risk for lenders, so they have lower interest rates and higher borrowing limits. But if the borrower fails to pay, the lender can seize the collateral to recover the loan. Mortgages and auto loans are examples of secured loans.

Pros and Cons of Unsecured Loans

Pros

  • Unsecured loans give you faster access to funds so you can address your financial needs quickly.

  • No risk to assets since unsecured loans don’t require collateral, so it’s safer for those without valuable assets to pledge.

  • Fixed repayment terms and predictable monthly payments so you can manage your finances better.

Cons

  • Higher interest rates for unsecured loans, especially for those with bad credit history, so the loan gets more expensive over time.

  • Borrowers with bad credit may have stricter eligibility requirements, higher interest rates, and lower borrowing limits.

  • Missing payments or defaulting on an unsecured loan can badly hurt your credit score and have long-term effects.

How to Get an Unsecured Loan

  • Check your credit score. Before applying for an unsecured loan, you need to check your credit score. A higher score means better terms and lower interest rates. A score of 720 and above gets you the lowest rates, while those with lower scores may have higher rates or stricter terms. You can check your FICO score from one of the major credit bureaus - Experian, Equifax, or TransUnion - before you apply. If your credit score is bad, you may want to improve it or explore other options like a secured loan.

  • How much do you need to borrow. Evaluate your financial situation to know the exact amount you need. This includes adding up all your expenses like debt consolidation, medical bills, or big purchases and your repayment capacity. Lenders recommend that total monthly debt payments should not exceed 30-40% of your monthly income, so make sure you borrow an amount you can comfortably pay without straining your finances.

  • Gather the required documents. When applying for an unsecured loan, lenders will ask for various documents to verify your financial standing. Commonly required documents are proof of identity (government-issued ID like a driver’s license or passport), proof of income (recent pay stubs, tax returns, or bank statements), and proof of address (utility bills, lease agreements, or bank statements).

  • Choose your options. Before you apply, take time to research different lenders, banks, credit unions, and online platforms. Compare the interest rates and loan amounts. Consider factors like customer reviews, reputation, and flexibility of the loan terms. Narrow down your options to 3-5 lenders that fit your financial situation.

  • Get pre-qualified. Many lenders offer pre-qualification, which allows you to see what terms you may qualify for without affecting your credit score. This is a soft credit inquiry and will give you an idea of the loan amount, interest rate, and repayment terms available to you. Pre-qualification is helpful when comparing different loan offers before making a final decision.

  • Select a lender. After you get pre-qualified offers, compare the exact terms offered to you, including interest rates, repayment schedules, fees, and loan amounts from the lenders. Once you’ve chosen, proceed with submitting your full application to the chosen lender.

  • Apply. Once you’ve reviewed your options and gathered the required documents, you can submit a full application. This will require a hard credit inquiry, which may affect your credit score slightly. The lender will evaluate your eligibility based on your credit score, income, and debt-to-income ratio.

  • Wait for approval. After you apply, the lender will review your financial information and decide if they will approve or deny the loan. This may take a few minutes to a few days, depending on the lender. If approved, the lender will offer you the loan amount, interest rate, and repayment terms.

  • Review the loan offer. Once you receive an offer, review the loan terms carefully. If everything looks good, accept the loan and sign the agreement.

  • Get the funds. After you accept the offer, the lender will disburse the funds to your bank account, usually within a few days. You can then use the loan for its intended purpose, whether it’s for debt consolidation, big purchases, or emergency expenses.

Conclusion

Unsecured loans are a flexible and convenient way to borrow without using personal assets. They are good for those who need funds for debt consolidation, medical expenses, or big purchases. While they have fixed repayment terms and no collateral requirement, they have higher interest rates, especially for bad credit borrowers. Potential borrowers need to know their financial capacity, check their credit score, and compare loan offers before making a decision. Although unsecured loans can give you quick access to funds, use them responsibly to avoid high-interest debt or credit score damage.

FAQ

Are unsecured loans always more expensive than secured loans?

Unsecured loans generally have higher interest rates than secured loans because they are not collateralized, which increases the risk for the lender. However, this doesn’t mean they are always more expensive in the long run. The total cost of an unsecured loan depends on many factors, including interest rate, loan amount, and loan term. Unsecured loans may have higher rates, but if the loan amount is smaller or the term is shorter, the total cost might still be lower than a secured loan with a bigger amount or longer repayment period. Consider all these factors when evaluating the true cost of a loan.

Can I get an unsecured loan with bad credit?

Yes, you can get an unsecured loan with bad credit, but it may come with challenges. Lenders offer higher interest rates and stricter terms to borrowers with lower credit scores. However, some online lenders and credit unions offer loans for bad credit borrowers and may be more flexible in their approval process. You can also consider applying with a co-signer or guarantor, which can improve your chances of approval and get better loan terms. Shop around and compare offers from multiple lenders to find the best rates and terms for your situation.

Can bankruptcy clear my student loan?

Declaring bankruptcy can wipe out many types of unsecured loans like credit card debt and medical bills, but student loans are more complicated. In most cases, student loans are not automatically discharged in bankruptcy. To have student loans forgiven, the borrower must prove that repaying them would cause undue hardship, which involves filing an adversary proceeding in bankruptcy court. This process can be long and tough. Private student loans, especially those used for non-educational expenses like living costs, have a higher chance of being discharged than federal student loans. Although there is a streamlined process for proving undue hardship, filing for bankruptcy is a difficult path for discharging student loans and borrowers should explore alternatives like income-driven repayment or deferment before pursuing bankruptcy.

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