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Unsecured Loan: What It Is, How It Works, & How To Get One
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Unsecured Loan: What It Is, How It Works, & How To Get One

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Unsecured Loan: What It Is, How It Works, & How To Get One

If you need to finance an upcoming project, unexpected expenses or even tuition, unsecured loans can help you get financing without pledging collateral like your home. These loans often come with less demanding qualification and application requirements than secured loans, and many lenders offer same- or next-day funding.

That said, unsecured loans pose more risk to lenders so you may be faced with higher rates and less favorable terms compared to secured loans. We’ll show you how unsecured loans work and help you decide if they’re a good fit for you.

What Is an Unsecured Loan?

Also called good faith loans or signature loans, unsecured loans are those that do not require the borrower to pledge any collateral. Common types of unsecured loans include personal loans, student loans and unsecured credit cards. You can get these loans from a wide range of traditional, online and government-backed lenders, and the application process is often less rigorous than for secured loans.

Unsecured vs Secured Loans

Because unsecured loans don’t require collateral, they are riskier for lenders than secured loans—instead of seizing assets if a borrower defaults, banks are limited to collection actions like wage garnishment. To limit their risk when extending unsecured loans, banks and other lenders often require a higher credit score to qualify. Unsecured loans also come with higher interest rates and less favorable terms than their secured counterparts.

Related: Unsecured vs. Secured Loans

How Unsecured Loans Work

Unsecured loans typically range from $1,000 to $100,000, which you can use for a range of purposes. In general, annual percentage rates (APRs) range from about 6% to 36%, and loan terms often extend from two to seven years. However, loan amounts, rates, terms and permitted uses vary by lender, so borrowers should shop for loans that meet their individual needs.

Many lenders offer online prequalification so you can compare likely rates without having to apply and undergo multiple hard credit checks. Depending on the lender, prospective borrowers also may be able to apply for a loan—and receive a lending decision—online. And, because unsecured loans don’t require collateral, applicants don’t need to wait for an appraisal or otherwise demonstrate the value of any assets.

Once an unsecured loan is approved, funds are disbursed as a lump sum and interest begins to accrue on the entire loan amount. With unsecured credit cards and other lines of credit, the borrower can use the funds on an as-needed basis and interest only accrues on the outstanding balance. Payments must be made on a monthly basis and are typically reported to the three major credit bureaus, though there is typically a grace period when reporting late payments.

What Happens If You Default on an Unsecured Loan?

If you default on an unsecured loan, the lender will send your missed payments to a collection agency. This will result in collection calls and, following continued nonpayment, may necessitate legal action to recoup the outstanding debt.

If such legal action succeeds, the lender may recoup the loan balance through wage garnishment or, in the case of federal student loans, seizure of future income tax refunds. A lender may also place a lien on your home or another valuable asset. What’s more, the default will result in a significant drop in your credit score and will remain on your credit report for as long as seven years.

Types of Unsecured Loans

There are many types of unsecured loans that you can use for a wide range of purposes. Not only can borrowers access traditional term loans—like personal loans and student loans—there are also unsecured revolving loans like credit cards and personal lines of credit. These are the most common types of unsecured loans:

  • Unsecured personal loans. Personal loans are most commonly unsecured, though some lenders offer secured options. You can use this type of unsecured loan for a range of personal uses, including everything from unexpected medical bills to home improvement projects and travel. Just check with your lender to make sure your intended use is permitted before getting a personal loan.
  • Personal lines of credit. If you’re facing expenses that will be spread over an extended period of time—like for home renovations—a line of credit lets you access funds on an as-needed basis. And, while certain lines of credit are secured, like home equity lines of credit, many lenders offer unsecured options.
  • Unsecured credit cards. Credit cards are a type of revolving loan that lets borrowers access a certain amount of spending power that must be paid down each month. While secured credit cards are available, most consumer cards do not require collateral.
  • Student loans. Both government-backed and private student loans are unsecured. That said, government-backed lenders may accelerate a loan so that it’s due immediately and can seize a borrower’s federal tax refund to recoup the outstanding loan balance.

How to Get an Unsecured Loan

The application process for an unsecured loan is more straightforward than for secured loans,

and you can often complete it online. Still there are a few important steps to take to ensure you’re getting the best deal from your lender. Follow these five steps when applying for an unsecured loan.

1. Check Your Credit Score

Borrowers should have a credit score between at least 610 and 640 to qualify for a personal loan, but the most competitive rates are reserved for those with a FICO score of at least 720. Use a free online service to check your credit score before you apply. Not only will this help you anticipate your likelihood of approval, checking your score gives you the opportunity to improve it before you even submit your loan application.

2. Evaluate Your Budget

After reviewing your credit score, take some time to evaluate your current income and expenses. While you won’t have any collateral at risk with an unsecured loan, late payments will still impact your credit score, so it’s important that any new debt payments fit within your budget.

What’s more, most lenders consider a borrower’s debt-to-income ratio (DTI) when reviewing their loan application. This metric represents the percentage of a borrower’s income she must commit to outstanding debt payments each month. Ideally, you should have a DTI of 36% or less to qualify for a new unsecured loan, but this requirement varies by lender.

3. Shop for Lenders and Prequalify

Once your finances are in order, start shopping for lenders that offer the most competitive APRs and flexible repayment terms. Luckily, many lenders offer prospective borrowers a quick and easy online prequalification process. This lets future borrowers see what kind of APRs and loan terms they’re likely to qualify for without submitting their application.

4. Gather Documentation

If you’ve found a promising lender and are ready to take the plunge, research its application process. Though not necessary, collecting any necessary documentation like tax returns or W-2s before you apply can speed up the application, approval and funding process.

5. Submit a Formal Application

Finally, complete a loan application and submit it online or in-person. Many lenders now offer a completely online application process as well as quick approval times and same- or next-day funding. That said, the exact application process varies by lender, and you may need to discuss your loan with someone over the phone or in-person.

Pros of Unsecured Loans

Unsecured loans are a popular financing option for borrowers, largely because of their flexibility and less stringent application requirements. Here are some advantages of unsecured loans:

  • Borrowers don’t need to own a valuable asset—like a home or vehicle—to qualify for an unsecured loan
  • Lenders cannot directly seize collateral if a borrower defaults on an unsecured loan
  • You can generally use unsecured loans for a wide variety of purposes
  • The application process is less extensive than for secured loans because it doesn’t require an appraisal of collateral

Cons of Unsecured Loans

There are still a number of disadvantages you should consider before you commit to an unsecured loan. These are the cons of unsecured loans:

  • Missed payments or default will have a negative impact on a borrower’s credit score
  • Default may result in legal action and subsequent wage garnishments
  • Due to the increased degree of risk, lenders often impose higher credit score requirements for unsecured loans than for secured loans
  • Interest rates and terms are also likely to be less favorable—especially for applicants with a weaker credit history

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