- Provided by banks, credit unions and online lenders, an unsecured loan is a type of loan that doesn't require any collateral.
- If you fall behind on payments on an unsecured loan, you don’t have to worry about losing your home, car or other asset.
- However, to get an unsecured loan, you need to meet a lender’s underwriting requirements for credit and income, which can be loftier than the ones you’d need to meet for a collateral-backed loan.
An unsecured loan is a debt product that doesn’t require any collateral, such as a house or car, for approval. Instead, a lender relies on your credit, income and other financial credentials to determine whether you qualify for the loan.
“An unsecured loan is only backed by the credit score and paying ability of the borrower,” says Mahesh Odhrani, a Certified Financial Planner and president of Strategic Wealth Design. “The lender does not have any collateral to take to recover its losses if the borrower does not pay the loan.”
Some common types of unsecured loans are personal loans and student loans. Unsecured personal loans often go by other names, such as debt consolidation loans or home renovation loans, but they all essentially work the same.
Inside this article
How do unsecured loans work?
You’ll need to meet a lender’s underwriting requirements to qualify and can use the funds for almost anything you want. Borrowers with the strongest credit tend to get the most competitive rates, while borrowers with weaker credit face higher rates and potentially lower loan limits.
If you can’t meet loan requirements on your own, some lenders let you apply with a cosigner. Adding a creditworthy cosigner to your application can help you qualify or get better rates. However, your cosigner will be equally responsible for the debt and will be liable for repayment if you can’t pay it back. (You could also apply for a joint loan with a co-borrower who would have equal access to the loan funds—and legal responsibility for repaying it.)
Unsecured loans are often installment loans that you pay off over time, according to a repayment term you agree to at signing.
How unsecured personal loans work
After approval, you receive a lump sum upfront that you can spend pretty much however you like. Some common uses of personal loans include home renovations, debt consolidation, medical bills and wedding expenses, but the list goes on.
After receiving the loan, you make monthly payments for a set period of time, typically two to seven years. Most unsecured personal loans range from $2,000 to $50,000, though some lenders offer up to $100,000. Fixed interest rates typically start around 6% and can go up to 36% (though there may also be origination fees).
When you apply for an unsecured personal loan, lenders will look at your credit, income, debt-to-income ratio and other factors. Your credit history gives the lender insight into how you’ve handled debt in the past. Since a lender sees someone with a positive credit history as less risky, it will offer better rates and terms to that applicant than to someone with a negative or thin credit history.
How Do Personal Loans Affect Your Credit?
How Do Personal Loans Affect Your Credit?
Whether you’re applying for a personal loan, repaying or refinancing one, your credit score can swing in different directions if you’re not careful.Find out more
Unsecured loan example
Let’s say that you want to borrow a personal loan to pay for home renovations. You kick off the process by checking your rates with a few different lenders. Many online personal loan companies let you check your rates with no impact on your credit score. If you see an offer you like, you can move forward and submit a full application.
For the sake of our example, let’s say you qualify for a $20,000 unsecured personal loan at an 11% interest rate and choose a repayment term of five years. Assuming no other fees, you’ll pay your loan off in full after making 60 monthly payments of $435. Over the life of your loan, you’ll pay back the full $20,000 plus $6,091 in interest charges.
If you opt for a shorter repayment term, your monthly payment will be higher but you’ll pay less in interest charges. Conversely, choosing a longer term will give you more affordable monthly loan payments, but you’ll be in debt longer and consequently pay more interest over the life of your loan. Toy with the numbers using a loan payment calculator like Calculator.net’s.
Pros and cons of unsecured loans
- You don’t have to pledge any collateral to borrow the loan
- The application process and funding time may be faster than they would be to borrow a secured loan
- You’re not at risk of losing your assets if you fall behind on payments
- Good-credit borrowers could qualify for competitive interest rates
- Unsecured personal loans can be used for almost any purpose
- You may see higher interest rates and lower loan amounts than you would on a secured loan
- Unsecured loans can be difficult to get approved for if you have bad credit (or you could get stuck with a high interest rate)
- Defaulting on an unsecured loan could damage your credit—your debt could also get sold to a collections agency, and a lender could bring you to court
Unsecured vs. secured loans: What’s the difference?
Unsecured loans, which don’t require collateral, stand in contrast to secured loans, which do. Some common examples of secured loans are home loans and vehicle loans, which are backed by your home and car, respectively.
Because unsecured loans don’t require collateral, they may be faster to obtain than secured loans.
“Unsecured loans are simpler to process and qualify for as the banks are using the individual’s credit score and income to qualify them,” says Odhrani. “The approval process is generally much quicker.”
Meet the Expert
In addition to his CFP designation, Odhrani is a Chartered Financial Consultant and has 17 years of industry experience. He’s also a member of the executive advisory board at his alma mater, the UNLV Lee Business School.
Secured loans, however, may come with lower interest rates and higher borrowing amounts than unsecured loans. Credit and income requirements may also be more relaxed, since a lender relies more heavily on the value of your asset than your credit score during the qualification process.
If you default on a secured loan, though, a lender could seize the asset that you pledged as collateral. Homeowners who default on their mortgages could see their home go into foreclosure, for instance, while borrowers who fall behind on their vehicle loans could lose their car.
On the other hand, a lender can’t seize your home, car or other asset if you default on an unsecured loan. They could decide to bring you to court, but they can’t directly take any of your belongings, since you didn’t back up the loan with collateral.
Missing payments on any type of loan, whether unsecured or secured, can severely damage your credit. Late payments and other red marks usually stay on your credit for seven years, making it difficult to qualify for other loan products in the future.