What Are Unsecured Personal Loans? Overview, and How It Works

unsecured personal loans

What if expenses come up in the middle of the month and you are still yet to receive your paycheck for the month? One of the best ways to raise quick funds for emergency expenses is via unsecured personal loans.

Unsecured personal loans are often less demanding in terms of qualification and
requirements for application. With unsecured personal loans, you can get funded the same day or in a few business days depending on your choice of lender.  

Nonetheless, it is essential to understand that because of the risks involved with unsecured loans, lenders may charge high rates with stricter terms when compared to secured loans. To understand how unsecured loans work, continue reading to the end.  

Unsecured Personal Loans: Definition  

Unsecured loans refer to a type of loan that does not require collateral. With unsecured loans, lenders do not require the borrower’s assets to serve as security for a loan application.

Rather, lending houses rely on creditworthiness to approve or decline a loan. Common examples of unsecured loans are:   

  • Personal loans
  • Student loans (signature loan)
  • Credit cards
  • A personal line of credit
  • Peer-to-Peer (P2P)

When we talk of unsecured personal loans, we refer to the amount of money you borrow from a lender to cater to various personal needs.

Unsecured personal loans can be for debt consolidation, it can also take care of wedding expenses or for your home renovation.

Some ways you can access an unsecured personal loan include credit unions, banks, and the online marketplace.

The money you borrow typically come with a loan term, which may include the duration of the loan, interest rate, and repayment period. Depending on the lender, a personal loan may also attract some fees.  

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How Does Unsecured Loans Work? 

Unsecured personal loans are often referred to as signature loans and do not require collateral to approve. Personal loan terms, which include approval and disbursement of funds mostly depend on the borrower’s credit score.

To increase the chances of getting approved for a personal loan, the borrower must first achieve a high credit score.  

Unlike secured loans where the borrower pledges the asset as collateral for the loan amount he/she is interested in, unsecured loans do not require any form of collateral.

For loan applicants who do not have a sufficient credit score to apply for a loan, some lenders provide the privilege of a co-signer for such individuals. The co-signers have the legal obligation of fulfilling a debt in case the borrower cannot meet up with their principal payment and interest in time.  

Unlike secured loans where the lender holds unto the borrower’s collateral in case they default, the case is different for unsecured loans. When a borrower cannot pay up what they owe in time, the lender can carry out certain actions to recover their money.

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They include;

  • Appointing a collection committee to help them recover the funds 
  • They can take the borrower to court  
  • If the borrower owns a house, it may place a lien on his house 

The borrower may also be ordered to pay what they owe the lender 

There are consequences when you default as a borrower, which includes low credit scores. To maintain good credit, scores and be eligible for better loan offers, it is best to clear your debt as at when due.  

Unsecured Loans: Types 

There are two broad types of unsecured loans, which are revolving and term loans. Whether it’s a credit card, a student loan, or a personal loan, all these are types of unsecured loans that can either be revolving or term loans.  

The revolving loan is a type of loan that comprises a credit limit that borrowers can spend, repay and spend again. Credit cards and personal lines of credit are all examples revolving around unsecured loans.  

On the other hand, a term loan is a loan that comprises an instalment payment over a given period. Here, the borrower continues to pay an equal amount of money over a given period known as the loan term.

Also, a consolidation loan to settle credit card debts or signature loans can be considered as an unsecured term loan.   

Over the past few years, there is a boom in the unsecured loan market powered by financial technology firms (Fintechs). There is a growth in the number of peer-to-peer (P2P) lending options on both mobile devices and on the web.  

According to Federal Reserve, the amount of revolving debt for US consumers as of October 2020 hit an all-time high with $979.6 billion.  

Before applying for unsecured personal loans to take care of expenses, it is important to understand what your monthly payment and interest will look like. Therefore, a personal loan calculator is a great tool that can help you calculate your monthly pay and interest for the amount you intend to borrow.   

Unsecured Loans as Opposed to Payday Loans 

A payday loan is an alternative way to raise funds to cater to personal expenditures. Payday lenders offer loans as merchant cash advances. They do not offer traditional loans and so, their loans do not have tangible collateral.  

One way Payday lenders secure their loans is by collecting a post-dated cheque from borrowers. Other Payday lenders may request an automatic withdrawal from the borrower’s checking account for loan repayment.

Payday loans are considered unsecured. However, they are partially secured and may have some negative implications for the borrower. 

It is important to note that many Payday loans come with hidden charges and high-interest rates and are considered predatory. Some states prohibit payday loans because of the same predatory reasons.  

Things to Consider When Applying for Unsecured Loans  

Applying for an unsecured loan is direct and less tasking than secured loans. In most cases, you can start and complete your registration and application online.

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However, there are still a few important things to take into consideration to ensure that your application is successful. Before applying for an unsecured loan. Consider the following steps:  

#1. Consider your credit score  

To qualify for personal loans, check to ensure that you have a credit score of at least 610. Though, to be eligible for the best rates, most lenders require a FICO score of at least 720.

There are free online services that can help you check your credit score before applying.

Checking your score helps you to expect the possibility of your loan application being approved. It also allows you to improve your score before applying.  

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#2. Weigh your budget 

Once you know your credit score, the next step is to weigh your income and expenditure.

While you may not lose any collateral to lenders when you default, your credit score remains at risk and may be affected negatively. Therefore, your debt must fall within your budget.  

Also, many lenders consider a borrower’s DTI ratio when going over their application. DTI represents the percentage amount a borrower must dedicate to paying outstanding debts monthly.

To qualify for a new personal loan, the borrower needs a DTI of 36% or less (the requirement may differ for different lenders).   

#3. Search for the Right Lenders

If your credit scores are okay and your finances are in good shape, the next step is to find the right lender.

Some things to consider before selecting a lender include, their APR, the flexibility of their loans, and loan terms. The better your choice, the more likely you are to qualify for a loan.  

#4. Prepare the Required Documents

Once you find the right lender, ensure to read their application requirements before proceeding with your loan application. Requirements usually vary according to different lenders.

Prepare any required documents and fill the online form (where applicable). Documents like tax returns/ W-2s can be of great help in speeding up your application even though they are not necessarily required for unsecured loans.   

#5. Send in a Formal Application for your Loan 

Complete a formal loan application and submit it to your lender of choice. While some lenders provide an online platform for this, others require you to apply in person.

Not that the application process can differ from one lender to the other and it may require you to discuss with an in-office assistant or with a customer care agent on the phone concerning your loan. 

Special Considerations

While lenders have the sole discretion to decide which loans to approve based on the creditworthiness of the borrower, there are laws available that guard against lending discrimination.

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One of such laws includes the Equal Credit Opportunity Act (ECOA) of 1974, which makes it illegal to deprive lenders on the ground of colour, race, sex, religion, and other non-creditworthiness causes when estimating an application for a loan or other areas of the transaction.

Today, lending practices have improved in the United States. Nonetheless, there are still some ugly incidents of discrimination visible in the system.  

Important Factors to Note About Unsecured Personal Loans 

  • Unsecured loans include personal loans, credit cards, and student loans.  
  • Most unsecured loans are backed by the borrower’s creditworthiness and no collateral is required.  
  • Unsecured loans pose a high risk to the lender, therefore, many lenders require a high credit score to approve a loan. 
  • If a borrower cannot clear the loan amount within the specified period in the loan term, the lender has the option of either appointing a collection agency to recover the funds or taking the borrower to court. 
  • Depending on the creditworthiness of a borrower, the lender can decide to either honor or decline a loan appointment.  
  • There are laws set up to protect borrowers from discriminatory practices.  

Advantages of Unsecured Loans 

  • You don’t need a valuable asset or collateral to be eligible for an unsecured loan 
  • Lenders do not have the legal right to seize collateral directly when a borrower cannot meet up with loan terms 
  • Borrowers can use unsecured loans to finance different personal needs 
  • The application process is easier and less complicated when compared to secured loans where you require a collateral appraisal 

Disadvantages of Unsecured Loans

  • Failure to make payments as at when due can have a negative implication on your credit score 
  • Defaulters may face legal actions and wage garnishment  
  • Because of the high risks involved, lenders often demand high credit scores and impose higher loan rates on borrowers. The conditions become less favorable for those with poor credit scores   

Conclusion

Unsecured loans can be a lifesaver, in emergencies. They also offer flexible payment terms and are less stringent application processes. However, they can also come at a cost.

Lenders may charge higher interest rates and require you to earn a high credit score to qualify for a loan. While unsecured loans are good for many advantages, It is, therefore, important to note that there are also some disadvantages to consider before applying for an unsecured loan.  

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