Unsecured loans: What are They and When to be Cautious

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.

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.

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 9.58%. If you were to borrow the same amount on one of your credit cards, you’d pay 14.61% 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 loans 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.

The bottom line

Borrowing money is always a big decision and it’s not something to be taken lightly. Ultimately, you're likely going to be a good fit for an unsecured loan if you have a good credit score and a stable, monthly income. Otherwise, you may be given less-than-favorable loan terms and it may be worth it to look into alternative options like a home equity loan.
If you’re thinking of going this route, consider using a personal loan calculator to get a sense of what your monthly payment could look like at your desired loan amount. Once you’re ready to start shopping around, you’re going to want to make sure that you obtain quotes from multiple lenders and that you review the loan terms carefully before making your final decision

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