Key takeaways
- Unsecured loans are debt products that do not require collateral but may come with higher interest rates and stricter credit requirements.
- There are various unsecured loans, including personal loans, student loans, and credit cards.
- When determining eligibility for an unsecured loan, lenders will consider factors such as credit history, income and debt-to-income ratio.
Unsecured loans are offered by banks, credit unions and online lenders. Unlike secured loans, they’re not backed by collateral and may be harder to get approved for than a secured option. However, they come with less risk as you won’t need to worry about your assets being seized should you fail to make the payments.
Most installment loans are unsecured. This includes student loans, personal loans and revolving credit such as credit cards. Eligibility will vary from lender to lender, but you’ll generally need good or excellent credit and a steady source of income to qualify. The most creditworthy borrowers are more likely to be offered the best loan terms and lowest interest rates. Although usage depends on the lender or lending institution, you can generally use an unsecured loan for nearly every legal expense.
What is an unsecured loan?
Unsecured loans are loans that don’t require collateral. They’re also referred to as signature loans because a signature is all that’s needed if you meet the lender’s borrowing requirements. Because lenders take on more risk when loans aren’t backed by collateral, they often charge higher interest rates and require good or excellent credit to get approved.
Unsecured loans are available as revolving debt — a credit card — or an installment loan, like a personal or student loan. Installment loans require you to pay back the total balance in fixed, monthly installments over a set period.
Credit cards allow you to use what you need when you need it. They often have higher interest rates than loans. If you miss a monthly payment, you’ll be charged interest on top of the principal amount.
Who should get an unsecured loan?
Borrowers who need money but aren’t comfortable pledging collateral to secure a loan can consider an unsecured loan when:
- Planning for a large purchase. Taking on debt can strain your finances, but if you need funds for a big upcoming expense, an unsecured loan can help.
- They have good credit. A high credit score unlocks more favorable unsecured loan terms and interest rates.
- They have reliable income. Although collateral isn’t needed for an unsecured loan, you’ll need steady income to repay the debt and avoid defaulting on the loan. Unpaid secured loans can negatively affect your credit.
- Consolidating debt. Unsecured loans are useful as debt consolidation tools that can make debt repayment simpler. This strategy can also help borrowers save money if they qualify for lower interest rates.
Types of unsecured loans
There are several types of unsecured loans to choose from. However, the most popular options are personal loans, student loans and credit cards.
A personal loan can consolidate debt, finance a large purchase, expense an ongoing project or finance home renovations. There are personal loans available for nearly everything, including wedding loans, pet loans and holiday loans. Technically these are just unsecured personal loans in which the funds are to be exclusively used for related purchases. Personal loan interest rates are typically lower than credit card rates.
- Loan amount: Around $1,000 to $50,000
- Average interest rate: 12.35 percent (as of June 19, 2024)
- Repayment timeline: Anywhere from two to seven years
Who a personal loan is best for: Good credit borrowers who know exactly how much funding they need.
There are two types of student loans: federal and private student loans. Federal loans are the better choice for most borrowers because they carry much lower rates and are available to every student attending a participating college. Private lenders offer private student loans and can come with higher rates and more stringent eligibility requirements. These loans are best used when filling funding gaps, as they don’t come with the benefits and protections that federal loans offer.
- Loan amount: Up to full cost of attendance (private loans only)
- Average interest rate: Up to 17 percent (private loans), up to 8.05 percent (federal loans)
- Repayment timeline: Anywhere from five to 20 years, but will vary for every borrower
Who a student loan is best for: Upcoming and current post-secondary education students supplementing their need-or merit-based financial aid.
Credit cards are one of the most common financing options. They’re a revolving debt, so the funds are available whenever needed. You can borrow up to your credit limit, which is assigned by the lender, and can borrow up to that limit. You can use a credit card to consolidate debt, for everyday spending, or to fund a larger purchase or experience. However, rates can be high and interest adds up fast if you carry a balance.
- Credit limit: Typically between $2,000 and $10,000
- Average interest rate: 20.67 percent (as of June 19, 2024)
- Repayment timeline: No specified timeline
Who a credit card is best for: Individuals with healthy spending habits looking for a long-term revolving line of credit.
Unsecured loans vs. secured loans: which is better?
Secured loans differ from unsecured loans in that secured loans always require collateral. The lender won’t approve a secured loan if a borrower doesn’t agree to provide an asset as insurance.
Secured loans exist for financing options including:
- Mortgages.
- Car loans.
- Home equity lines of credit.
- Some types of personal loans.
Borrowers will not encounter unsecured mortgages as the home is always used as collateral. Unsecured auto loans exist but are uncommon.
Pros and cons of unsecured loans
Unsecured loan options may be less risky than other loan types for certain borrowers, but not all. When taking out any long-term debt, making a fully educated decision is crucial to promoting financial health.
Pros of unsecured loans
- No collateral required.
- Fast access to funds.
- No risk of losing assets.
- Fewer borrowing restrictions.
- Competitive rates for those with strong credit.
Cons of unsecured loans
- Risk of losing assets.
- Might have lower borrowing limits for those with low credit scores.
- Might have higher interest rates for those with low credit scores.
- Harder to get approved.
- Has fewer borrowing options than secured loans.
Qualifications for an unsecured loan
To limit their risk, lenders want to be reasonably sure you can repay the loan. Lenders measure that risk by checking a few factors, so they may ask about the following information when you apply for an unsecured loan (and tailor the loan terms according to your answers):
Your credit
Lenders check your credit reports to see how you’ve managed loans and credit cards in the past. Generally, they look for a history of responsible credit use (typically one or more years), on-time payments, low credit card balances and a mix of account types. They’ll also check your credit scores, which are calculated based on the information in your credit reports. Consumers with FICO credit scores around 700 or higher usually qualify for the best interest rates.
Your income
Knowing you have the means to meet your financial obligations, including the loan payments, lowers the lender’s risk. The lender may ask to see proof of stable, sufficient income, such as a current pay stub.
Your debt-to-income ratio
To calculate your debt-to-income ratio (DTI), add all your monthly debt payments and divide that total by your gross monthly income.
For example, if you have $500 worth of existing debt payments and $2,000 in gross income each month, your DTI is $500 / $2,000 = 0.25 or 25 percent.
Lenders use this number to measure your ability to repay a loan. The lower the ratio, the better. Every lender will have a different requirement for your DTI; however, credit.org asserts that the maximum is usually no higher than 36 percent.
Assets
Although unsecured loans don’t require collateral, the lender may want to know you have savings. They know you’re less likely to miss loan payments when you’re prepared to cover financial emergencies.
How to apply
If an unsecured loan is right for you, applying takes several simple steps:
- Determine how much you need. Only borrow what you need, even if the lender approves you for a higher amount.
- Research top lenders. You can find unsecured loans through national and local banks, credit unions and online lenders.
- Compare unsecured loan offers. Some lenders offer prequalification so you can see which loans you might qualify for before you apply. Look at each lender’s interest rates, fees, loan terms and amounts and special features.
- Submit an application. Complete a formal loan application after checking preliminary offers and selecting your preferred lender. This can be done online or in person through most lenders.
- Provide documentation. If the lender asks for additional documentation, submit it in a timely manner. For example, this might come up if you don’t have strong credit.
- Accept loan funds. If approved, the lender will tell you how you’ll receive the loan funds. You’ll receive the money as a lump sum if it’s an installment loan. For revolving loans, such as a credit card, the lender will issue you a credit card to draw funds from the account as needed.
The bottom line
The main advantage of an unsecured loan is that you don’t have to pledge collateral. But if you default on the loan, you could still face serious consequences, like major damage to your credit. Plus, a lender could take you to court to garnish your wages.
Taking out an unsecured loan can be good if you plan to repay the debt. If you decide an unsecured loan is right, compare rates, terms, and fees from as many lenders as possible before applying.
