Unsecured loans can help you with a big purchase or refinancing high-interest debt. But is an unsecured personal loan right for you? Let’s find out!
If you’re in the market for a loan, you may have seen unsecured loans as an option through your bank or credit card company. In fact, it seems every time you turn around, you have an offer in your mailbox. But what is an unsecured loan and what are they used for?
We’ll dig into the lingo to help you decide if an unsecured loan is the right method for you and your needs. Let’s get started!
What Is an Unsecured Loan?
An unsecured loan is a type of personal loan that doesn’t require collateral. Collateral is a valuable item or asset that is worth the amount of the loan (or greater) such as your home, fine jewelry, or a vehicle. If you stop making payments on your car, for example, your lender can take the vehicle from you, sell it, and get their money back.
An unsecured loan, however, doesn’t have anything of value as backup. Because of this, these loans generally have much higher interest rates and have caps for how much you can borrow.
Where Can I Get an Unsecured Loan?
Unsecured loans are available through banks, credit unions, online lenders, and credit issuers such as Mastercard or American Express. Each lender will have its own requirements, so check for eligibility before applying.
Applying for an unsecured personal loan might count as a hard inquiry on your credit report, especially if you’re responding to a prequalified offer. A hard inquiry can impact your credit score for up to a year and remain on your credit report for two years, so keep that in mind before you apply.
How to Apply for an Unsecured Loan
First, take time to research available unsecured loans. You can start with your bank or credit union, since you might get better rates or perks based on your existing relationship. You can also compare rates from online lenders and credit issuers before making your decision.
It’s a good idea to make a hand-written list or spreadsheet to track loan application requirements so you can lay out your options to make the best decision. Don’t be shy about asking questions before processing an application.
Some questions to ask might include:
- What loan amounts are available?
- What are the monthly payment terms?
- Are there penalties for prepayments?
- What is the annual percentage rate (APR) range?
- Do you have other options that might be better for me?
- What is the recommended credit score to apply?
- What is the suggested debt-to-income ratio for successful applicants?
While you can find much of this information online, you might also want to speak with a customer service representative so you can ask a few questions before applying. This will lessen the risk of being denied, which can negatively impact your credit score.
How Does an Unsecured Loan Work?
Once approved, funds are often accessible through a credit card, written check, or direct deposit.
Your debt-to-income ratio and other unique financial circumstances will determine the approved amount, but unsecured loans come in all sizes. Interest rates will likely vary based on your creditworthiness. If you have a credit rating of 750 or higher, you might be able to qualify for a loan with a low interest rate.
Unsecured loans require you to pay back the loan in monthly installments. In some cases, you might also have a loan period, meaning your unsecured loan has a start and end date by which all money must be paid back.
How Can an Unsecured Loan Be Used?
Unsecured loans can be used for a variety of reasons – medical expenses, debt consolidation, and even furniture. If your lender has any stipulations about how money can be used, they will be included in the terms of your agreement.
However, the best way to pay for optional purchases — such as vacations or home improvement projects — is by saving the money instead. High-yield savings accounts are well suited for this, and some even reward you for saving every month.
Pros and Cons
There are ups and downs to unsecured loans for both the lender and borrower, but let’s start with the glass half full.
Here’s how unsecured personal loans can benefit you:
- The application process can be more efficient for the borrower and require less paperwork and labor for the lender.
- Borrowers assume no direct risk to personal property since collateral isn’t required.
- Borrowers can use the funds for a variety of personal projects.
On the flip side, it also means you are subject to higher interest rates and could take a huge hit to your credit score for late payments or a defaulted agreement. Additionally, loan amounts might be smaller than secured loans and minimum monthly payments could be higher.
For lenders, they assume greater risk with unsecured loans. While your credit history and past financial behavior are great indicators, the lack of required collateral for the loan means that you can default on it without a direct, immediate impact to your assets. At that point, the lender would have to seek legal remedy or engage in collections to recover the loss.
Unsecured Loans vs. Secured Loans
A secured loan is an alternative to an unsecured loan. These loans can also be issued by a bank, credit union, online lender, or credit issuer. Examples of secured loans include mortgages, home equity lines of credit, and vehicle loans. Secured loans require collateral, which also determines how much you can borrow.
Defaulting on a secured loan means that the lender can take what you put up for collateral, but it also means that you could have access to better interest rates and higher loan amounts. Plus, if you have a poor credit score, you might find it easier to gain approval for a secured loan than an unsecured loan.
You’ll pay monthly financing charges based on your APR, but you might also incur fees for initiating the loan (called “loan origination”), making late payments, paying less than the minimum, or making prepayments. In some cases, you might be able to get a discount for setting up an automatic monthly payment, so make sure to ask about all options available to help you pay off your loan faster.
The first step you should take is to research unsecured loan offerings with financial institutions you trust and compare them with other financial products — such as credit card offers, secured loans for poor credit, or saving the money instead.
Educating yourself on the terms, benefits, and alternatives of unsecured loans will help you determine if taking one out is the right move for your goals.
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