The difference between secured and unsecured loans can be boiled down to one word: collateral.
When you apply for a mortgage, for example, you’re seeking a type of secured loan. If you default on that loan, the lender can possess your home as a means of recouping their funds.
For an unsecured loan, however, there is no collateral involved. Instead, the lender uses a borrower’s creditworthiness to determine whether or not the applicant is eligible for a loan. If the borrower defaults, the lender may enlist the help of a collection agency or even take the borrower to court.
Unsecured loans can be a fitting option for borrowers with good credit — sometimes. Take a look at the information below to learn which borrowers may benefit from an unsecured loan and which ones should steer clear.
What is an unsecured loan?
Unsecured loans are a type of loan, typically a personal loan, that allows individuals to borrow funds without collateral, such as a vehicle or home.
If you default on an unsecured loan, lenders can’t seize your personal property, so they rely on a different set of credentials to ensure a borrower will repay their funds. First and foremost, unsecured loans require borrowers to have a good or excellent credit score. Lenders also look for other financial qualifications, such as a borrower’s debt-to-income ratio.
Unsecured loans are available as personal loans, student loans, and even credit cards. They typically have shorter terms (around two to five years) and higher fixed interest rates than secured alternatives and are usually for $50,000 or less.
You can receive an unsecured loan from not only a bank or credit union, but also peer-to-peer lending sites, which make the application process fast and easy for those who need quick cash.
What are unsecured loans for?
Unsecured loans can be used for a number of reasons.
You can fund personal expenses, such as home renovations, an upcoming wedding, or even large purchases like a boat or horse. Other individuals may use unsecured loans to fund a new business endeavor. Student loans are also a common type of unsecured loan since students typically don’t have the collateral needed for secured loans. In addition, some borrowers use unsecured loans for debt consolidation, for purposes like mounting medical bills, credit card debt, and such.
In fact, with the exception of uses like gambling or illegal activities, there are few restrictions as to how a borrower may use their unsecured personal loan funds.
Who should use an unsecured loan?
- Those with good credit. If you have healthy credit (650 or higher), but little to no assets, an unsecured loan may be the ideal route for you.
- Those in need of a small loan with short terms. Unsecured loans are better for borrowers who need a smaller loan and can realistically expect to repay the loan in a short period of time. Those who need more than $50,000 and more than a few years to repay the funds should consider a secured loan instead.
- Those who need cash quickly. Unsecured loans are often easier to qualify for (based on your credit history), so those who need cash fast may find that an unsecured personal loan is the best option. In fact, thanks to peer-to-peer lenders, some applicants can get approved in less than 24 hours.
Who shouldn’t use unsecured loans?
- Those with bad (or even fair) credit. Individuals with bad or even fair credit should consider alternative options before applying for an unsecured loan. Since unsecured loans are designed for creditworthy customers, lenders who advertise unsecured loans to those with bad credit may be predatory payday lenders.
- Those who might default on their loan. The consequences of defaulting on an unsecured loan are serious. Not only will your credit score suffer considerably, but the lender may take matters a step further, selling your debt to a collection agency or perhaps even taking you to court.
How can you qualify for an unsecured loan?
Since lenders don’t have any collateral to fall back on if a borrower defaults, unsecured loans are generally reserved for individuals with a healthy financial history.
Most importantly, you’ll need a good (even excellent) credit rating and repayment history. Lenders typically look for a credit score of 650 or higher, although some may cater to applicants with lower scores. With that said, be careful not to accept a loan from a payday lender and consider a cosigner, which may help those with bad credit qualify and perhaps even get a lower interest rate.
In addition to your credit history, the best applicants will have a steady income stream and a low debt-to-income ratio (below 40%). The better your financial history looks, the better rate you’ll receive.
How can you apply for an unsecured loan?
One of the reasons people often opt for an unsecured loan over secured is because the application process is generally quick and easy.
Unsecured loans are available through a number of providers, including banks, credit unions, and even peer-to-peer lending sites. That said, the best place to start your search is via a personal loan marketplace like Upgrade, which allows you to prequalify and compare quotes from a number of reputable providers all in one location. For each offer, pay close attention to details like the interest rate, loan term, as well as any potential fees or penalties that could be applied.
Once you’ve selected your preferred provider, you can typically complete the formal application online, which requires a hard pull on your credit report. Make sure you’ve gathered documents and information that show your employment history, income, and debts.
After you send the finished application, it shouldn’t take long to receive your loan offer. Scan the document thoroughly to make sure you understand the terms of the loan and can afford the monthly payments. When you’re ready, sign on the dotted line! You should receive information on how your funds will be delivered shortly after.
When should you avoid unsecured loans?
Generally speaking, unsecured loans are riskier than secured loans for a number of reasons.
The interest rates are higher, which means your debt will pile up rapidly if you fail to make payments. The terms are shorter, which means you’ll have less time to repay the loan. And if you aren’t able to keep up with the payments, your credit score will suffer, which prevents you from qualifying for future lending opportunities for several years.
With all this said, don’t pursue an unsecured loan unless you’re confident in your ability to repay the funds.
Alternatives you should consider
Borrowers should remember that unsecured loans often come with high interest rates, so alternatives like a credit card with 0% APR may be a better fit.
It can take years to rebuild your credit, so if you’re at all concerned about your ability to repay the loan balance, it may be best to pursue a more flexible alternative. Ask a friend or family member if they’d be willing to loan you the cash.
If you believe that a personal loan is still your best bet, start your search at a credit union, where interest rates tend to be lower.
Unsecured loans can help you cover a variety of expenses, from an upcoming wedding to updating your home.
However, since unsecured loans aren’t backed by collateral, such as a home or vehicle, lenders look to a borrower’s creditworthiness to determine their eligibility. Applicants can receive funds relatively quickly, but they’ll pay more in interest since the exchange is a little riskier for the lender involved.
There are certainly a number of pros and cons when it comes to unsecured loans, so make sure to do your research and use a site like Upgrade to compare quotes.