Every day, people go on the hunt for the right loan to fit their financial needs. One of the options they’re sure to come across is a personal loan. Among the most common uses for personal loans are paying off credit card balacnces to save on interest costs, funding home renovations, and debt consolidation. Those aren’t the only uses, though, as personal loans grow in popularity as a way to fund different financial goals. Personal loans come in two primary flavors: secured and unsecured.
Unsecured personal loans, in particular, provide an opportunity to borrow for those who cannot or do not want to use collateral to obtain a loan. However, there’s more to unsecured personal loans than just the collateral factor.
How do you know if an unsecured personal loan is the right choice for you? We’ll dive into exactly what an unsecured personal loan is, the benefits of an unsecured personal loan, and how to choose the best loan for your situation, whether you’re looking for extra cash to start an artisanal cafe or cover every wall in your house with shiplap.
What Is an Unsecured Loan?
An unsecured loan is a loan from a lender that is not backed by collateral. To understand, compare this to a secured loan, which is backed by an asset such as your home, bank account balances, or car title. To have a loan “backed” by an asset means that a bank or lender has the right to take that asset in the event of missed payments.
Loans backed by collateral—secured loans are also called “collateralized loans”—are generally considered by banks to be less risky, because they are able to recoup missed payments by seizing the collateralized property.
When loans are viewed as less risky by lenders, they tend to have lower interest rates, if everything else is equal. Lenders will also generally offer higher dollar amounts when a loan is backed by an asset of value.
Unsecured loans, on the other hand, are not backed by collateral. Therefore, they are likely to have higher interest rates and lower loan amounts than secured loans. Some online lenders, like SoFi, offer low, fixed-rate, unsecured personal loans which may be used for a variety of purposes—like consolidating credit card debt or paying for home improvements.
Different Types of Unsecured Loans
Personal loans are generally unsecured. These unsecured personal loans are often installment loans, paid back over a pre-established term on a set payment schedule with a fixed interest rate. Borrowers typically pay personal loans back monthly, over a term of one to five years .
Federal student loans are another type of unsecured loan, since they aren’t backed by collateral. Federal student loans come with their own unique requirements, protections, repayment options, grace periods, and federal regulatory requirements that must be met. Of course, student loans are only available to current students.
It may seem odd, but a credit card is also a type of unsecured loan. Essentially, when you’re approved for a credit card, you’re being approved for a revolving line of credit. It’s not a lump sum loan; it’s a loan where you’re basically borrowing what you need when you need it—and you can borrow again and again as long as you pay it back.
(Ideally, you’re also paying your statement balance in full each month when it comes due so you don’t incur finance charges.) However, a credit card often has higher interest rates than an unsecured personal loan.
Why People Choose Unsecured Loans
Although it might be easier to qualify for a secured loan, the lender will likely need fewer pieces of documentation for an unsecured loan and less time to process the paperwork. Why? With a secured loan, the lender needs to provide proof of the value of the collateral—and that can take time.
For example, if you were to use your home as collateral for a secured loan, a lender may require an appraisal in order to determine how much equity you have that can be used as personal loan collateral. This takes time, as the appraiser needs to complete some research and inspect your property.
Also, there is often an extra cost for the appraisal. Unsecured personal loans are often available in a shorter amount of time. Many online lenders are making personal loans more accessible to those with solid borrowing histories and a reliable income. Unsecured personal loans are not backed by an asset; they are instead backed by a borrower’s creditworthiness.
While secured loans may be less risky from a lender’s perspective, that might not be the case for the borrower. If you are using your home or other asset as collateral (like a car), you are putting that asset at risk.
In the event you’re unable to make payments for any reason—a job layoff, or a medical or family emergency—the lender could seize your property. Ultimately, every borrower must decide what makes the most sense for them and their financial situation when making the secured versus unsecured loan decision.
Lastly, unsecured personal loans usually have fixed interest rates, which means that your interest and payment won’t change.
What do people use Unsecured Personal Loans for?
Here are a few of the most common uses for an unsecured personal loan:
Credit card payoff:
Credit cards have notoriously high annual interest rates (called annual percentage rates, or APRs); the average interest rate right now is just over 17% . To understand how much interest you are paying on your credit card debt, you can use a tool like our Credit Card Interest Calculator.
Due to their oppressive costs, some borrowers find relief by consolidating their credit card debt using a lower interest rate personal loan. Even a reduction of 1% could mean savings on sizeable credit card balances. To see how much money you could potentially save, you can check out our Personal Loan Calculator.
Debt consolidation is the process of paying off multiple debts—like credit cards—using one new loan, effectively consolidating those debts into one. Ideally, the new loan has a lower interest rate than the existing loans, so the borrower is able to save money.
This strategy also could be helpful for anyone who has trouble managing multiple payments each month because of differing due dates.
Unfortunately, medical expenses can put a person in a tough financial situation, including the need to file for bankruptcy. Sometimes, medical bills can be negotiated and payment plans put into place.
If these options don’t provide a reasonable path toward paying for past medical services, some borrowers may opt to take out a personal medical loan to cover any remaining balance.
Whether it’s something big like adding a bedroom to a home or something small like replacing kitchen fixtures, homeowners might consider an unsecured personal loan to obtain funding for a home project, also called a home improvement loan.
This could be especially useful for someone who needs cash for immediate repairs or emergencies. An unsecured personal loan is an alternative to taking out a home equity loan or home equity line of credit for remodeling or repairs, both of which are secured loans and require equity in your home.
Deciding Between Secured and Unsecured Personal Loans
If your credit isn’t great, then you may want to seek out a secured loan and guarantee your repayment with collateral. Otherwise, you could opt to apply for an unsecured loan, but know it might come with a higher interest rate. If you want to borrow a large amount, then you might also need to consider a secured loan.
For example, if you want to borrow $40,000 for home repairs, it might behoove you to consider a home equity loan or home equity line of credit, which uses your house as collateral. The downside, of course, is that you’re putting your home on the line, and if it decreases in value, you could also ultimately find yourself underwater. (Whereas borrowing $40,000 with an unsecured personal loan wouldn’t put your house directly at risk.)
Some borrowers will first attempt to build up their credit score in order to qualify for a lower-interest rate unsecured loan. Small secured loans can actually help you build credit , as long as you pay them back on time. Another option you may want to consider if you are looking for more favorable loan terms is to ask someone to cosign on your loan, or co-borrow with you, assuming they meet certain criteria.
A cosigner is typically someone who is responsible for the loan if you are unable to make payments—though they share liability for the loan, they typically don’t sign a loan agreement, apart from the cosigner addendum. A co-borrower, on the other hand, takes out the loan with you, and is an equal partner in repaying the loan and liability. (If you end up considering a SoFi personal loan, it’s worth noting that SoFi does not allow cosigners, only co-borrowers.)
Applying for an Unsecured Personal Loan
First, and as with any financial commitment, make sure your finances are in order. Unsecured personal loans typically require a strong credit score and a history of reliability. If you’re planning on taking out an unsecured personal loan in the future, you can start by doing things like making timely credit card payments to help responsibly build up your credit.
Because unsecured personal loan lenders are trusting you to make payments and do not have any collateral to repossess, showing that you’re a responsible borrower can go a long way toward securing that loan at the rates and terms you’d like.
Related: How to Pay Tax on Personal Loans
If you have a weaker credit score, however, all is not lost. Many lenders will consider loaning money to borrowers with a weaker credit score or not enough credit history if you can bring along a cosigner (or co-borrower) with a more favorable credit history, income, and other positive financial backgrounds.
Next, find a reputable lender that offers unsecured personal loans. Some things to look for include the interest rate they would offer you and terms that work for you, and check for extra fees like origination fees so that you understand the true cost of the loan.
And, of course, make sure you will be able to meet the repayment terms. For some of life’s many curveballs, or opportunities, the occasional need for an unsecured personal loan might arise. Some examples include taking out a relocation loan to help you fund your big move to a new city, adding to your home or property, freeing yourself from high-interest debt, or unanticipated personal expenses. In any case, an unsecured personal loan can help.
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