An unsecured loan is borrowing without any collateral.
The borrower does not need to place any of his/her assets as a security (collateral) for the personal loan. Such loans are approved per the creditworthiness of the borrower which is measured by credit score and proof of income.
The amount of the unsecured loan is always lower than the secured limit. Also, such loans have higher interest rates due to the significant risk attached to the lender.
Key Takeaways
- No collateral is required for unsecured debt
- Higher interest rates due to larger risk exposure attached to the lenders’ side
- Depends on credit score and previous debt performance
- Usually issued for shorter terms
- An approval process is quicker if the credit score is satisfactory
- Affects future critic approval as every payment impacts the credit information bureau
How does an unsecured debt work?
An unsecured loan is a type of personal loan offered by banks, credit unions, and online lenders. Based on your creditworthiness (measured by the credit rating report) and proof of income, you can directly apply to the lender.
The loan limit of the unsecured loan is decided by the lenders’ benchmark which is directly associated with your Debt-to-income ratio (DTI).
The APR of such unsecured loans varies from 5% to 36% (varied by your credit score). Usually, borrowers with a credit score of 690 or more are entitled to the lowest APR.
Here’s a table that illustrates how the range of credit scores affects your Annual Percentage Rate (APR) of unsecured loans.
| Credit Score Range | Credit Rating | Approximate APR Range |
|---|---|---|
| 720 – 850 | Excellent | 5% – 10% |
| 690 – 719 | Good | 10% – 15% |
| 630 – 689 | Fair | 15% – 20% |
| 580 – 629 | Poor | 20% – 30% |
| 300 – 579 | Very Poor | 30% or higher |
Types of unsecured loan
Unsecured loans include personal term loans, student loans, credit card, peer-to-peer loans, payday loans, personal line of credit, signature loans, and debt consolidation loans.
The below table explains each type with an example
| Type of Loan | Purpose | Example |
|---|---|---|
| Personal Loans | Various personal expenses | Consolidating credit card debt |
| Credit Cards | Everyday purchases, revolving credit | Buying a new laptop |
| Student Loans | Education-related expenses | Covering college tuition |
| Peer-to-Peer Loans | Various personal or business expenses | Funding a small business startup |
| Payday Loans | Emergency short-term needs | Covering unexpected car repairs |
| Personal Lines of Credit | Flexible, revolving credit | Home renovation expenses |
| Signature Loans | Various personal expenses | Financing wedding expenses |
| Debt Consolidation Loans | Combining multiple debts | Consolidating credit card debt |
| Medical Loans | Healthcare expenses | Paying for dental procedures |
Personal loan can be used for debt consolidation, home improvements, medical expenses, or major purchases. Usually, a compound interest rate is applied in such loan with a close-end nature.
Credit card is another example of unsecured debt that does not require you to put any asset as collateral. Lenders usually allow you a credit card depending on your income volume and frequency. However, some people may need a cash deposit as a security for credit cards who do not have any income proof at all.
WIth a student loan, someone can finance tuition fees, books, and other institutional fees. Such debt does not require any security as the amount is directly credited to the educational institution’s account and the bank collects money from his future earnings. Usually, student loans come with a grace period but with higher interest in the future.
Peer-to-Peer or, P2P loans are facilitated through online platforms that connect borrowers directly with individual lenders. These loans can be used for various purposes and often have competitive interest rates.
Payday loans are usually given for short term with high interest rates to support any urgency of the borrowers. Payday loans can only become beneficial if you do not have other means of financial assistance and you are bound to incur the cost.
Signature loans are usually given to people with income regularity and decent credit scores. In such cases, the borrower’s signature is the only guarantee for the lenders. Usually, signature debts are issued for the short term and have high interests.
A debt consolidation facility allows someone to merge previous loans with issuing a new loan. In nature, debt consolidation is unsecured with lower interest rates. With the debt consolidation, lenders get access to earn interest for a few additional years and that is why they offer lower interest rates. Furthermore, debt margins are only allowed when you show regularity with your earlier debt installments.
Lastly, a medical unsecured loan is given to incur any sudden medical expenditure. For example, you may ask the lender for a medical loan of $2000 for a wisdom tooth extraction.
Pros and Cons of unsecured loans
| Pros | Cons |
|---|---|
| No Collateral Required | Higher Interest Rates |
| Faster Approval Process | Lower Borrowing Limits |
| Flexible Use | Stricter Qualification Requirements |
| Builds Credit History | Impact on Credit Score |
| Fixed Interest Rates Available | Potential Fees |
| No Risk to Assets | Shorter Repayment Terms |
| Limited Tax Benefits |
One of the strongest sides of the unsecured loan is that the borrower does not need to offer any collateral to the lender. It reduces the risk of losing your assets in case you become defaulted.
Since the debt amount is smaller for the unsecured loans, the processing becomes significantly faster. Also, you can enjoy the flexibility of use for a wide range of purposes, including debt consolidation, home improvements, medical expenses, and more.
If you can successfully manage small unsecured debts, you will eventually be building your credit score. However, the interest rate of such borrowings is higher due to the higher risk attached to the lenders.
As said earlier, unsecured borrowing amounts are lower than secured debts, and there will be stricter qualification requirements such as specific credit scores and proof of income.
Additionally, shorter repayment terms are another big downside for unsecured borrowings and there are fewer tax advantages. For instance, interest paid on unsecured loans is generally not tax-deductible.
How to qualify for an unsecured loan?
To qualify for any unsecured borrowings, you need to have the required credit score, and adequate debt-to-income (DTI) ratio, gather all required documents, and share true information.
Here we list some activities to improve your chances of getting approved:
- Obtain your credit report and score from a credit bureau. Aim for a score above 650, but higher scores (700 and above) increase your chances of approval and getting better terms.
- Review your credit report and find any disputes or inaccuracies with the credit bureau.
- Try increasing your credit score by paying down existing debt or avoiding new credit accounts.
- Calculate your DTI by dividing your total monthly debt payments by your gross monthly income. Aim for a DTI below 40%.
- Gather all necessary documents such as Proof of income (pay stubs, tax returns, bank statements), employer’s letter, Identification (driver’s license, passport), and Proof of residence (utility bill, lease agreement).
- Research and compare lenders, including banks, credit unions, and online lenders. Consider interest rates, fees, loan terms, and customer reviews.
- Use online prequalification tools offered by lenders to get preliminary offers.
Where can you get an unsecured borrowing?
Usually, banks, credit unions, and online lenders allow an unsecured credit facility.
Traditional banks such as Wells Fargo, Chase, and Bank of America, offer unsecured personal loans with competitive interest rates, especially for existing customers with good credit.
Credit unions such as Navy Federal Credit Union, Alliant Credit Union, PenFed Credit Union, often offer lower interest rates and more personalized service compared to banks. Such institutions are member-owned so, the process gets faster than the banks.
Online lenders such as SoFi, LendingClub, Avant, Prosper – provide a convenient way to apply for unsecured loans, often with a quick application process and fast funding.
Furthermore, P2P platforms (LendingClub, Prosper, Upstart) connect borrowers directly with individual investors willing to fund their loans. These platforms often offer competitive rates.
Also, there are some personal finance companies (OneMain Financial, Discover Personal Loans) that specialize in personal loans and may offer flexible terms and faster approval processes.
Some employers can even offer unsecured personal loans as part of their employee benefits packages. These loans might have favorable terms and repayment through payroll deduction.
Some credit cards offer cash advances or personal loans. These can be convenient but often come with higher interest rates. Credit cards from issuers like Capital One, Citi, or American Express offer personal loan options.
Some fintech companies (Earnin, Dave, MoneyLion) and financial apps offer personal loans with innovative features and quick access.
So, this is your call to decide between the lenders.
Here’s a lenders’ comparison table to guide you further.
| Source | Pros | Cons |
|---|---|---|
| Banks | Competitive rates, trusted institutions, in-person service | Stricter eligibility requirements, slower approval process |
| Credit Unions | Lower rates, personalized service, non-profit | Membership required, limited branches |
| Online Lenders | Fast application, quick funding, flexible terms | Higher rates for lower credit scores, online-only interactions |
| P2P Lending Platforms | Competitive rates, direct investor funding | Varied investor interest, potential for higher fees |
| Personal Finance Companies | Specialized loans, flexible terms, fast approval | Higher interest rates, potential for aggressive marketing |
| Employer/Workplace | Favorable terms, easy payroll deduction | Limited availability, potential impact on employer relationship |
| Friends and Family | Low/no interest, flexible terms | Risk to personal relationships, lack of formal structure |
| Credit Card Companies | Convenient, quick access to funds | High interest rates, potential for high fees |
| Financial Apps/Services | Innovative features, quick access | Higher interest rates, less traditional support |
| Educational Institutions | Low rates, designed for students | Limited to educational expenses, availability varies |
How does the lender determine the borrowing limit?
Usually, lenders consider your credit score, income & employment, Debt-to-income ratio (DTI), credit utilization ratio, repayment history, and loan amount with strong purpose while determining the borrowing limit.
A credit score is the most crucial factor for unsecured borrowing, except for a few types such as Payday or P2P. Credit performance is the first step where the lender determines if you are giving them the confidence to repay your debt. Per the risk-return relationship theory, a lender will always demand higher interest when his risk is on the upper side.
Your income health, income frequency, and employment history are the second factor that gives additional confidence to the lender about your future economic earnings. Besides, income has also a direct impact on the credit score. On the prequalification stage, banks will also see your income trend to predict your future earnings before determining your loan limit.
Debt-to-income ratio (DTI) suggests your financial leverage. DTI calculates the correlation and proportion of your borrowing against your monthly income. Most lenders prefer a DTI of below 36. ALternatively, a lender will allow 36% borrowing of your total income to be on the safe side.
Credit Utilization Ratio is another tool lenders use while determining your borrowing limit. This ratio measures the amount of credit you are using compared to your total available credit. A lower utilization ratio (ideally under 30%) is favorable as it suggests you are not over-relying on credit
Additionally, your history of making timely payments on existing debts also significantly impacts your borrowing limit. All together, lenders assess your purpose of borrowing, and your creditworthiness, and ensure if you are likely to repay the loan.
What happens if you become bankrupt while having any unsecured debt?
If you become bankrupt with any unsecured loan liability, your credit history will show it for the next 10 years and you won’t be able to get any further loans.
What would be your lender’s action against your bankruptcy?
Typically lender appoints a recovery agent even before you claim an official bankruptcy. However, after you are bankrupt, an automatic stay is issued, which temporarily prevents creditors, including those of unsecured loans, from collecting debts. This means that lenders cannot pursue legal actions, garnish wages, or call you for repayment during the bankruptcy process
Lenders need to file an official proof of claim if there’s any outstanding amount of your unsecured loan. The court then decides the validity and amount to be repaid from your available assets
In most cases, unsecured debts like personal loans are discharged (forgiven) at the end of the bankruptcy process. This means you are no longer legally obligated to repay those unsecured debts but, this is not that easy. You need to prove to the court that you do not have any means of assets to settle your liabilities.
What would be the impact on borrowers after claiming bankruptcy?
- Inability to access new loans
- Assets will be liquidated as per Chapter 7 or Chapter 13 in the U.S.
- Re-establishing a new credit history would be tougher and near to impossible
Conclusion
Unsecured debt is accessible if you have income proof and a decent credit score. We suggest you to assess your financial health and debt repayment plan carefully as any missed payment would make your future loans costly.
