What are unsecured loans?

Definition and Examples of Unsecured Loans

How Unsecured Loans Work

Unsecured Loans vs. Secured Loans

Advantages and Disadvantages of Unsecured Loans

Definition and Examples of Unsecured Loans

Unsecured loans are loans that are approved without the need for collateral. If the borrower defaults on the loan, the lender has few options for recouping the owed amount, aside from filing a lawsuit.

Key Takeaways:

• An unsecured loan is one that does not require collateral or a down payment to obtain.
• Unsecured loans come in three main forms: personal loans, student loans, and unsecured credit cards.
• Unsecured loans are also referred to as “good faith loans” or “signature loans.”
• A secured loan requires collateral.
• Collateral can be a house, car, cash, investments, or other assets.

How Unsecured Loans Work

When applying for an unsecured loan, the lender reviews your borrowing history to see if you have successfully repaid loans in the past. Based on the information in your credit reports, a computer generates a credit score, which is a shorthand assessment of your repayment ability.

To qualify for an unsecured loan, you need to have good credit. If you have taken out few loans in the past, or have a bad credit history due to past financial difficulties, it is possible to rebuild your credit over time. You should consider taking steps to improve your credit score before applying for an unsecured loan.

Lenders for unsecured loans will also want to ensure that you have enough income to repay any new loans. When you apply for a loan, whether secured or unsecured, the lender will require proof of income. They will then evaluate the burden of the new loan payment on your monthly income. This is usually done by calculating the debt-to-income ratio.

Pay stubs, tax returns, and bank statements might provide sufficient proof of income.

Unsecured Loans vs. Secured Loans

Unsecured Loan Secured Loan

No collateral required Requires collateral

Common for loans without recoverable tangible assets Common for loans with recoverable tangible assets

The main difference between unsecured and secured loans is the requirement for collateral. When applying for a secured loan, you must provide assets – whether it’s your home, car, investments, or cash – to receive the loan. If you default on the loan, the collateral can be used to repay the lender. Secured loans are commonly used with mortgages and auto loans.

If you take out a mortgage loan, the home becomes the collateral. If you default, the lender can foreclose on the home and resell it – this process is known as “foreclosure.” If you fail to repay your auto loan, the lender can repossess the vehicle.

Advantages and Disadvantages of Unsecured Loans

Advantages:

• Lower risk for the borrower (loss of assets)
• Potential for debt relief

Disadvantages:

• Higher risk for the lender leading to higher interest rates
• Higher costs over the loan term

Explained Advantages:

From the borrower’s perspective, the main advantage of an unsecured loan is reduced risk. If you take out an unsecured loan and cannot repay it, you are not at risk of losing your assets; you will only be putting your credit rating at risk. For individuals or businesses with unsecured loans, there is also a chance for debt relief if you file for bankruptcy.

Explained Disadvantages:

Because unsecured loans do not require collateral, the lender takes on greater risk, which typically translates into higher interest rates and less favorable terms. While unsecured loans may be less risky for the borrower, it is important to know how much that can cost you over the life of the loan. You may find that putting an asset up as collateral is more beneficial than the extra money you will pay in interest.

Source:

https://www.thebalancemoney.com/unsecured-loans-definition-and-explanation-315638