Unsecured Loans: What are They and When to be Cautious

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Last Updated:Aug 06, 2024

Unsecured Loans: What are They and When to be Cautious

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Fast Facts

Loan type:

Unsecured; needs no collateral

Impact on credit:

Hard credit inquiry

Funds availability:

Quick; as soon as 2 business days

Interest rate:

Varies by the lender

Whether you need to consolidate credit card debt or finance a big purchase, unsecured loans can be a viable option to help you get the money you need. Unlike secured loans, these debt securities do not use physical assets as collateral, which can make them easier and faster to obtain than some other loan options.

That said, these loans are not the right fit for every financial situation. Here’s what you need to know about them before signing on the dotted line.

In this article

What are unsecured loans?

At its core, the phrase “unsecured loan” refers to a type of loan that is not backed by a form of collateral. With a secured loan, like a mortgage or a car loan, the lender has the option to repossess the item if you decide to stop making your monthly payments.

In contrast, unsecured loans are not tied to a specific asset, so there is nothing for the lender to collect if the borrower defaults on repayment.

Since unsecured loans carry more risk for the lender, these loans often have more stringent eligibility requirements than secured loans. Typically, qualifying for one of these loans is based largely on creditworthiness, or the strength of your credit score. This means that borrowers with bad credit will face higher interest rates while those with good credit can expect to receive the lowest rates.

The most common types of unsecured loans are personal loans and student loans. In particular, personal loans can be used for a variety of purposes, including home improvement, debt consolidation, or financing a big purchase. These loans can also vary greatly in size and may be worth anywhere from $1,000 to $100,000. Meanwhile, student loan funds are generally used for educational purposes.

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Banks compete, you enjoy low rates

APR: 6.99% - 35.99%
Loan Term: 12-144 months
Credit Score: Poor, Fair, Good, Excellent

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Pros and cons of unsecured loans

Pros

You can access funds faster. Since it's often possible to obtain an unsecured loan with just a signature and a quick look at your credit report and assets, you’ll usually be able to access your money faster than you would with another type of loan.
Borrowers with good credit can get competitive rates. As far as loan rates are concerned, personal loans are a fairly affordable option. According to the most recent data from the Federal Reserve, the average interest rate on a personal loan is currently 12.36%. If you were to borrow the same amount on one of your credit cards, you’d pay 24.7% in interest, on average.
No collateral is needed. Since there is no physical asset being put up as collateral for your loan, if you are unable to keep up with your loan payment, nothing will be repossessed. That said, missing a payment or paying late will hurt your credit profile.

Cons

You may face stricter qualifying standards than you would with a secured loan. Since the lender has less recourse with an unsecured loan, they often impose stricter qualifying standards to maximize their chances of being repaid. With that said, qualifying is likely going to be largely based on credit approval, your income, and your debt-to-income ratio.
Those with lower credit scores may face less favorable loan terms. If your FICO score could use some work, you may be given less favorable repayment terms than someone with a cleaner credit history. In particular, you may be given a higher interest rate and a lower borrowing limit.

Loan terms to consider when shopping for an unsecured loan

Whether you’re shopping around for a debt consolidation loan or another type of personal loan, it can be helpful to gather a few different loan offers before deciding which one is right for you. After you have your quotes in hand, it’s a good idea to compare the loan terms.

Here’s a closer look at what should factor into your decision.

Loan amount: As mentioned above, different loan options may come with different borrowing limits. You’ll want to ensure that the loan amount on your quote is enough to cover your expense.
Interest rate: The interest rate is a charge passed on to you in exchange for the privilege of borrowing money. In addition to shopping around for the lowest rates, you should determine whether you’re being offered a fixed interest rate, which stays the same for the life of the loan, or an adjustable interest rate, which can change from month to month.
Annual percentage rate (APR): Where unsecured loans are concerned, the APR combines the interest rate and any fees associated with the loan. For example, if your loan comes with an origination fee, which many lenders charge in exchange for facilitating the borrowing process, that will be included in the annual percentage rate.
Fees: Additionally, you should also verify if there are any conditional fees associated with your loans, such as late fees or a prepayment penalty.
Available discounts: Lastly, always be sure to ask about any available discounts. For instance, some lenders will offer an autopay discount if you allow the lender to automatically charge your account each month.

Get Your Rate

Banks compete, you enjoy low rates

APR: 6.99% - 35.99%
Loan Term: 12-144 months
Credit Score: Poor, Fair, Good, Excellent

Get My Rate

FAQs

Can I pay off my unsecured loan early?

Many lenders allow early repayment, but some may charge a prepayment penalty. It's important to check your loan terms for any such penalties.

What happens if I miss a payment?

Missing a payment can result in late fees, an increased interest rate, and a negative impact on your credit score. Continued missed payments could lead to default and potential legal action by the lender.

Is an unsecured loan a good idea for debt consolidation?

Unsecured loans can be a good option for consolidating high-interest debt, such as credit card balances. By combining multiple debts into one loan with a lower interest rate, you can simplify payments and potentially save on interest.

The bottom line

Borrowing money is always a significant decision and should not be approached lightly. If you're considering an unsecured personal loan, it's essential to understand that your eligibility, primarily, hinges on your credit history, credit approval, and FICO Score. A good credit score and a stable monthly income can make you an attractive candidate for an unsecured loan, potentially leading to loan offers with a lower interest rate. However, without a strong credit profile, you might find the loan terms less favorable.

Before you submit your loan application, it's prudent to review your credit report. This will give you a clearer understanding of your financial standing and help you anticipate the loan rates you might qualify for. Utilizing a personal loan calculator can also offer insight into what your monthly payments could look like based on your desired loan amount and the rates you qualify for.

When you're ready to explore your options, obtaining quotes from multiple lenders is critical. This will not only allow you to compare loan offers but also to scrutinize the loan terms closely. Each loan offer can vary significantly in terms of interest rates, repayment terms, and additional fees, so it's vital to make an informed decision.

In cases where your credit score might not qualify you for favorable unsecured loan terms, considering alternative options such as a home equity loan could be beneficial. These alternatives might offer more attractive terms based on collateral rather than solely on your credit report and income.

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Tara Mastroeni is a real estate and financial writer whose work has appeared on Forbes, Business Insider, LendingTree, Realtor.com, ApartmentTherapy.com, The Motley Fool, and Freshome.com.

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