Unsecured Loans - Definition and Explanation

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Unsecured loans are loans that have not been “secured” with any type of collateral. For example, the bank does not have the ability to take your house or car if you stop making payments on an unsecured loan.

An unsecured loan is approved based solely on your promise to repay (and the lender’s confidence in your ability to make payments). These loans are sometimes called “signature loans” because your signature on the loan agreement is all that you bring to the table.

Examples

Unsecured loans come in a variety of flavors.

  • Credit cards are a common form of unsecured loan (even though you might not think of them as “loans”)
  • Student loans are generally unsecured
  • “Personal” loans, which you can use for any purpose you want, are often unsecured loans

Compare and Contrast

Sometimes it’s helpful to look at what isn’t an unsecured loan – just to reinforce the concept.

Auto loans are secured loans. When you borrow to buy a car (or borrow against your car title), the lender has the right to take your car away if you stop making payments.

Home loans are also secured. Whether you borrow for your home purchase or you get a second mortgage, you risk being forced out of your home through foreclosure if you fail to repay the loan.

When loans are secured, your credit will still be damaged if you stop making payments – even after the lender takes your collateral. In some cases, the collateral is sold but does not bring in enough to pay off your loan.

As a result, you will lose the asset, have damaged credit, and possibly still owe a deficiency.

Approval for Unsecured Loans

To get a secured loan, you do not need to pledge anything as collateral. Instead, the lender will approve a loan application based on your ability to repay (as opposed to the lender’s ability to sell your assets and collect what you owe).

Lenders determine whether or not you’re likely to repay by evaluating several factors.

Your credit: lenders check your borrowing history to see if you’ve successfully paid off loans in the past. Based on the information in your credit reports, a computer creates a credit score which is a shortcut for evaluating your creditworthiness. To get an unsecured loan, you’ll need good credit. If you’ve done very little borrowing in the past (or you have bad credit because you’ve fallen on hard times in your past), it is possible to rebuild your credit.

Your income: lenders want to be sure that you have enough income to repay any new loans. When you apply for a loan (whether secured or unsecured), lenders will ask for proof of income. Your pay stubs, tax returns, and bank statements will most likely provide sufficient proof of income. Then, lenders will evaluate how much of a burden your new loan payment will be relative to your monthly income. They typically do this by calculating a debt-to-income ratio.

If you’re not able to qualify for an unsecured loan based on your credit and income, you might still have options. One approach is to ask a co-signer to help you get approved, but this can put everybody in a difficult situation.