What is an unsecured loan? Here’s a breakdown:
Unlike secured loans — which are backed by an asset, such as a home or a car — unsecured loans are covered by little more than the borrower's promise to pay them back.
“Unsecured loans are not backed by collateral,” says Katie Ross, education and development manager at American Consumer Credit Counseling.
Ross says unsecured loans can make sense in several different circumstances, including when you need to:
- Consolidate debts
- Make a large purchase, such as for home furnishings
- Pay for an emergency
Sometimes, an unsecured loan is a revolving loan. This means the lender give you a spending limit — such as several thousand dollars — and you can repeatedly spend that money, and then pay back the amount you have borrowed. Credit cards are an example of this type of loan.
By contrast, unsecured loans can also take the form of a term loan. This means you borrow a specific amount of money, then agree to pay it back under agreed-upon terms within a certain time frame.
Using a personal loan to consolidate debts would be an example of this type of unsecured loan.
You typically need good credit to qualify for an unsecured loan. A solid credit history reassures the lender that you will repay the loan on time and according to the loan terms.
Downsides of unsecured loans
While an unsecured loan can make sense for many consumers, there are downsides to using this type of borrowing, Ross says.
“Unsecured loans may carry a higher interest rate,” she says.
For example, credit cards have come with interest rates that are notoriously high. Personal loan rates tend to be lower than the rates on credit cards, but still high compared to the rates on secured loans.
That’s because the lender is taking a bigger risk with an unsecured loan. With a car loan or home loan, the lender can seize the asset if you fail to pay back the money you borrowed.
Ross says another drawback of unsecured loans is the fact that consumers are usually limited on the amount of money they can borrow.
Even though there is no collateral to back an unsecured loan, lenders still have options to get their money back if you fail to repay.
For example, the lender might hire a collection agency to come after you. Or, the lender could take you to court in hopes of getting repaid through a garnishment of your wages.
Using an unsecured loan responsibly
If you plan to pursue an unsecured loan, do your homework before signing on the dotted line.
For instance, it makes no sense to apply for a personal loan if you know you will struggle to afford the monthly payments.
“Make sure you have a complete understanding of the loan terms, and a plan to pay the loan off,” Ross says.
It’s also important to do so in a timely manner, she adds. Paying off your debt helps improve your debt-to-income ratio — the amount of money you owe compared to the income you bring in. That helps boost your credit score.
“You look good as a borrower that can demonstrate creditworthiness,” Ross says.
Paying off the loan more quickly also help you save money interest charges over the life of the loan, and puts “more money back in your pocket sooner for other uses, such as savings,” she says.
Editor's note: This story was originally published by PrimeRates.
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