Unsecured Loan: What Is It and Should You Get One?
Do you know the difference between an unsecured loan and a secured one?
- March 30, 2020
- 8 min read
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Whether you’re someone looking for financing for personal reasons or an entrepreneur in need of money for your business, unsecured loans are something you should consider. Unsecured loans are extremely common and there’s a good chance that you’ve already borrowed an unsecured loan yourself, even if you don’t know it. For instance, if you have a credit card that didn’t require a cash deposit to get, then you have a form of unsecured borrowing. There are many other types, so read on to find out what unsecured loans are and whether you should get one.
An unsecured loan is a form of borrowing money that is approved without requiring collateral. With a secured loan, you’re required to provide collateral, meaning you pledge an asset — such as property, a vehicle or cash — in order to secure a loan. On the other hand, with an unsecured loan, you don’t pledge assets. Instead, the qualification and approval are based on the borrower’s credit history and income. Thus, with an unsecured loan, lenders do not have the right to take any physical assets from you for lack of payment. A secured loan, like a mortgage, does give lenders to right to do this, for example, when a home is foreclosed on for failure to repay.
Since qualifying for an unsecured loan is heavily dependent on credit history, you’ll need to make sure your credit score is in good shape. If your credit score is not great and you go ahead with a loan application, you could really damage your score. This is because the lender will likely perform what’s called a hard pull of your credit. This will ding your credit score, sending it down temporarily, which could be concerning if your credit already isn’t good. Plus, you’ll likely get denied for the loan anyway.
The fundamental difference between unsecured loans and secured loans is the lack of collateral required to get an unsecured loan. There are two broad categories of unsecured loans:
- Revolving: Also referred to as revolving credit, this loan type includes credit cards and personal or business lines of credit, in which you can pay down the balance and then spend again against your credit limit, allowing you to use the line of credit over and over again assuming you pay it off.
- Term: An unsecured term loan has a set duration, monetary amount and repayment schedule, and includes loans like student loans and personal loans. The amount of money you are loaned is finite — once you spend it, it is gone and must be repaid.
It’s very likely you’ve encountered one of the many forms of unsecured loans that exist but hadn’t known that they were unsecured. Below you’ll find a top-level overview of various types of loans that are commonly made as well as whether it’s unsecured or unsecured.
|Types of Unsecured and Secured Loans|
|Unsecured credit cards||Unsecured||Credit cards are a form of lending because you borrow money when you spend with a credit card and repay it, but on a revolving, not term, basis.|
|Personal loans||Unsecured||Personal loans are available from banks, credit unions and online lenders, and are unsecured loans you can use for any purpose you want.|
|Student loans||Unsecured||There are some small exceptions, but overall, student loans through the Department of Education and private student loans are usually unsecured and must be spent on education-related purchases like tuition, books and student housing.|
|Auto loans||Secured||When you borrow money to buy a car — or borrow against your car title, if you already have one — the lender has the right to take your vehicle away if you stop making payments. The car serves as collateral, which makes it a secured loan. If you don’t repay your car loan, your car can be repossessed.|
|Home loans and HELOCs||Secured||If you borrow money to purchase a home or get a second mortgage, the property serves as collateral to secure the loan. With a home equity line of credit (HELOC), your home’s equity serves as collateral. If you fail to repay the loan, you risk being forced out of your home through foreclosure.|
|Secured credit cards||Secured||Borrowers with a low credit score or no credit history may be able to obtain a secured credit card. With these, you send the card issuer a deposit to hold as collateral and you’re given a credit card with a limit that usually matches the amount of your deposit.|
|Business loans||Unsecured or secured||These loans can be secured or unsecured. If your lender requires that you make a personal guarantee, you may have to pledge your home or other assets as collateral.|
Business loans can be either secured or unsecured, in part because business loans are a broad category. Business loans can, for instance, take the form of term loan or line of credit, with no collateral to secure them. Or, business loans can be asset-based, meaning the asset serves as the underlying collateral for the loan. Equipment loans are a variation of this, in which the equipment you’re financing acts as collateral for the loan, not unlike an auto loan.
Though unsecured loans can come in a variety of forms, they possess some shared characteristics. Because there is no underlying collateral with unsecured loans, they have important and unique qualities that you should know about before getting one. Here’s a look at some characteristics of unsecured loans:
Without collateral backing the loan, lenders put a major emphasis on your creditworthiness and income. Your household income is a significant factor in determining your approval as well as your potential credit limit. Lenders want to make sure that you have sufficient income to repay any new loans. When you apply for a loan — either secured or unsecured — lenders often will ask for proof of income. Most borrowers provide this in the form of pay stubs, tax returns and bank statements. From here, lenders evaluate how much of a burden monthly loan repayments will be compared to your monthly income, what’s called calculating your debt-to-income ratio.
Creditworthiness is even more important to get an unsecured loan than a secured one. Lenders need to know that you’ll repay the loan they’re extending to you and, by looking at your credit score and history, they can get an idea of how reliable you are as a borrower. With no collateral securing the loan, your credit history becomes the central basis of how lenders determine whether to make an unsecured loan to you. In most cases, a FICO score of 680 or higher means you’re not a subprime borrower and you have a chance at getting an unsecured loan. The higher your personal credit score, the better your odds of getting a loan, but always remember, there’s no guarantee.
Interest rates on loans, of course, vary from loan to loan, lender to lender, and so forth. But in general, since there’s no collateral with unsecured loans, banks and lenders need to make their investments worthwhile. As a result, unsecured loans have higher interest rates than secured loans.
A few examples can make this clear. For instance, according to the Federal Reserve Bank of St. Louis, the average finance rate on 60-month auto loans — which are secured loans — is 5.37% APR. For 30-year fixed-rate mortgages — another secured loan — the average rate is 3.29% APR. Compare both of those interest rates to the average interest rate across all credit card plans, 14.87% APR as of November 2019. When lenders have nothing to repossess, as with an unsecured loan, interest rates are typically higher as the lender is taking on considerably more risk.
You can get unsecured loans from a vast number of sources. Unsecured credit cards alone can come from several different issuers — Discover, American Express and Capital One, for example — and from any number of banks across the country. Student loans and personal loans are just as widely available, both through traditional lenders and online and alternative lenders.
Unsecured business loans are also widely available, coming in many forms and from many sources. Traditional, brick-and-mortar banks offer unsecured business loans as do online and alternative lenders. Most banks, in conjunction with credit card issuers, offer unsecured business credit cards and they can usually extend unsecured business lines of credit as well. Both of these unsecured business loans provide considerable flexibility for business owners, especially when it comes to dealing with cash flow issues.
As with most things in finance, unsecured loans carry their own advantages and disadvantages. Depending on your circumstances and goals for using the money, some of these pros and cons may be acceptable to you or not. You’ll need to weigh the advantages and drawbacks with your own personal goals and values.
Here’s a look at some of the key advantages of unsecured loans over other types of financing:
- No collateral required: When getting an unsecured loan, you won’t need to put up a physical asset or another asset as collateral for the loan. This is especially good for small businesses just starting out that lack sufficient assets to offer lenders as collateral.
- No risk of having your property taken away: Since there’s no underlying collateral to secure the loan if you fail to repay an unsecured loan, there’s no asset for the lender to seize. This is a marked contrast to having your vehicle repossessed or home foreclosed because you failed to repay the lender.
- Better during bankruptcy circumstances: If you face bankruptcy and have balances on unsecured loans, called unsecured debt, bankruptcy courts usually classify credit card balances, personal loans, medical bills and utility payments as nonpriority unsecured debts. As nonpriority unsecured debt, the debt only gets paid if there’s money left over and, typically, the bankruptcy court discharges this kind of debt. If you have secured debts and face bankruptcy, you’ll still need to pay or surrender the collateral.
The nature of unsecured loans, namely, not requiring collateral, can be great for you. It also, however, produces some of the drawbacks of unsecured loans that you should be aware of.
- Higher interest rates: With no collateral, lenders are taking on more risk when they extend unsecured loans to you. As a result, these loans will have higher interest rates than loans backed by collateral, like auto loans and home loans.
- Harder qualifications to meet: Again, because there’s no collateral, lenders have to compensate for this with stricter standards for loan approval. Hence, the major emphasis on your personal credit score and history, as well as your household income.
- Loan amounts of usually smaller: Since there’s increased risk involved in originating unsecured loans, lenders tend to keep the amounts on the smaller side when compared to secured loans. You can see this when comparing credit limits on credit cards or personal loans to secured loans: Most credit card limits and personal loan maximums pale in comparison to the size of the average mortgage loan — but that doesn’t mean you can’t borrow more than enough money for your personal or business purposes.
Unsecured loans are simply loans that are not backed by the underlying collateral. Secured loans are made based on the underlying collateral, like a home, vehicle or piece of equipment, which can then be seized by the lender if you fail to repay on time and on the established terms. Unsecured credit cards are probably the most ubiquitous form of unsecured loans, however, personal loans and especially student loans have dramatically increased in number in recent years. As with any type of financing, your most important job as a borrower is to do your homework and understand how unsecured loans work and could fit your needs. As part of this homework, you need to know your credit score and should be constantly striving to improve it, even if it’s in good shape.
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