Unsecured Loans: Definition and Explanation
Unsecured loans are loans that are approved without the need for collateral. Collateral is when you pledge an asset to secure a loan. With an unsecured loan, instead of pledging assets, borrowers qualify based on their credit history and income. Lenders do not have the right to take physical assets (such as a home or vehicle) if borrowers stop making payments on unsecured loans.
These loans are also known as “signature loans” because your signature on the loan agreement is all that you bring to the table. You promise to repay, but you don’t back up that promise by pledging collateral.
Types of Unsecured Loans
Unsecured debt comes in several forms, including:
- Unsecured credit cards: Even though you might not think of credit cards as loans, you borrow money when you spend with a credit card.
- Student loans: Although some people take cash out of their homes to pay for school, student loans through the Department of Education and private student loans are typically unsecured.
- Personal loans: These loans, available from banks, credit unions, and online lenders, are unsecured loans you can use for any purpose you want.
Compare and Contrast
To better understand unsecured loans, let's take a look at common types of secured loans:
- Auto loans: When you borrow to buy a car (or borrow against your car title), the lender has the right to take your vehicle away if you stop making payments. The vehicle serves as collateral, which makes it a secured loan.
- Home loans: 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.
- Secured credit cards: Borrowers with a low credit score or no credit history may be able to obtain a secured credit card. With these cards, you send the card issuer a deposit to hold as collateral. You are given a credit card with a limit that usually matches the amount of your deposit. For example, if you send $500 as collateral, you may be approved for a credit line of $500. If you don't make credit card payments, the card issuer uses your deposit to pay off the credit card.
- Business loans: These loans can be secured or unsecured. If your lender requires that you make a personal guarantee, you may have to pledge your home or other assets as collateral.
Even with secured loans, it’s possible to damage your credit if you stop making payments. The fact that the lender takes your collateral doesn’t change that.
In fact, sometimes lenders sell collateral, but the sales proceeds are not enough to pay off your loan balance. When that happens, you lose the asset, damage your credit, and still owe money on the deal because of a deficiency judgment.
What’s more, lenders may charge penalty fees, which increase the amount you owe. Eventually, lenders may take legal action, and if they win a judgment, they may be able to take cash from your bank accounts or garnish your wages.
Approval for Unsecured Loans
To get an unsecured loan, you do not need to pledge anything as collateral. Instead, the lender will evaluate your 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 look at several factors to decide whether or not you’re likely to repay.
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 over time.
Consider taking steps to improve your credit score before you apply for an unsecured (or a secured) loan.
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 can’t qualify for an unsecured loan based on your credit and income, you might still have options.
- Co-signer: One approach is to ask a co-signer to help you get approved, but this can put everybody in a difficult situation. The co-signer will be 100% responsible for repaying the debt if you’re unable to do so for any reason.
- Secured debt: You can also try pledging collateral. However, you risk losing assets if you’re unable to keep up with payments. You can pledge physical assets, but you can also use cash in a bank account or other financial assets to secure a loan.
- Borrow less: If your debt-to-income ratios are causing problems, a smaller loan should result in lower monthly payments. If you can still accomplish what you need with less debt, that might work well for everybody.