An unsecured loan is a helpful financial tool that enables you to borrow a lump sum of money without putting up any collateral. However, you do have to have decent credit to earn the trust of lenders. A secured loan, on the other hand, requires an asset like real estate or a vehicle. With both loan types being beneficial in certain circumstances, the right solution for you depends on your situation.
What is an unsecured loan?
An unsecured loan is a loan that is only secured by a borrower’s credit and financial profile — no physical assets. Common examples of unsecured loans include credit card purchases, student loans and personal loans.
Qualifying for an unsecured loan
Lenders that offer unsecured loans evaluate potential borrowers by pulling their credit reports to see how well they have handled credit in the past. Ideal borrowers have established credit histories, both installment and revolving credit accounts, good payment records, minimal negative marks, a low credit utilization ratio and a good credit score.
Additionally, lenders check the income situation of applicants including how long they’ve had a job and how much they make per year. The more financially responsible a borrower appears, the less risk they present to the lender. Thus, your credit and financial strength will impact if you can qualify as well as the rates and terms offered to you.
What happens if you can’t pay an unsecured loan?
If a borrower has an unsecured loan and can’t pay it back for some reason, the lender will pursue them to collect the outstanding balance, plus any fees or penalties. If the borrower doesn’t pay or doesn’t work out some sort of agreement, the account may be handed off to a collection agency. The holder of the debt can sue the borrower — also known as entering a judgment against them — to collect the debt. If this happens, they can take further action to collect the debt like garnishing wages or putting liens on assets. However, in many cases, the lender will write off the account as bad debt. Any unpaid debt will cause your credit score to drop and will stay on your credit report for seven years.
When are unsecured loans a good idea?
An unsecured loan can be a good solution for people with at least fair credit and a stable job who want to borrow for expenses such as school, career training, home improvements, car repair, debt consolidation, weddings and vacations. It’s always best if you borrow to invest those funds in something that will offer returns, like career training courses or home improvement projects.
Unsecured versus secured loan
An unsecured loan is not backed by any asset. If you default on the loan, lenders cannot seize something you own to recover their losses unless they sue you. However, a secured loan is a loan backed by an asset, like a car or house, meaning the asset serves as collateral for the loan from the beginning. So if you default on a car loan, the lender can come to take the car to recoup its costs. If you default on a mortgage, the lender can foreclose on your home and sell it.
Secured loans present less risk to the lender, so they typically have lower interest rates. For example, the average APR on a home equity line of credit is around 6.25%, on a fixed-rate mortgage is 3.75% and on a five-year auto loan is 4.61% Alternatively, the average APR on a credit card is 17.57% and on an unsecured personal loan, it’s about 21%.
Although your credit and income will be checked when applying for a secured loan, the eligibility requirements are likely to be more lenient than those on unsecured loans. On an unsecured loan, you and your ability to pay is the only security, so your credit report and income are the key determinants. When assets are in the picture, lenders have more leverage in terms of enabling them to approve people who present more risk.
Whether a loan has fees and the cost of those fees, varies from one loan product to the next. Mortgages are secured loans with very high associated fees due to the common closing costs. Some — not all — unsecured personal loans come with origination fees which range from 1% to 6% of the loan amount. Car loans can come with an application fee of $100 to $500. The bottom line is, be sure to check for fees on any loan you get, including secured and unsecured loan types.
When it comes to the time it takes to get the money from a loan, unsecured loans typically pay faster. Once you’re approved for an unsecured loan, the lender just needs to transfer the money over to you and that’s it. With some unsecured personal loans, like the ones available through Upstart, you can actually get approved and have the money in your account as soon as the next business day. With a secured loan, the process can take a bit longer because the asset has to be inspected, verified, appraised and so on. In summary, secured loans have more lenient eligibility requirements and lower APRs but are more complicated. Unsecured loans are pretty simple and can be processed fast but have higher APRs and stricter credit and financial requirements.
The process you have to undergo to get an unsecured loan is often very easy and quick — if you qualify. In many cases, you can get access to the money within a couple of business days. The downside is that the cost of borrowing is going to be more than you’ll pay on a secured loan. However, if you don’t have any assets or don’t want to put them at risk, the cost can be worth it.
Secured loans take a bit longer to secure in many cases but can be helpful for those with less impressive credit reports and/or more modest financial histories. They are often utilized for home or car purchases, but some lenders offer personal loans secured by assets such as investment accounts, vehicles or property. If you have collateral and need to borrow, a secured personal loan can help you save on the interest costs. Ultimately, the right solution for you will depend on your situation and borrowing needs.