What Is an Unsecured Loan? Everything You Need to Know Before You Borrow

If you need more financial flexibility or extra funds, you might be weighing your options. While credit cards can certainly pay for these same expenses, personal loans are often a more affordable alternative. 

Personal loans come with two options: secured and unsecured. With an unsecured loan, you won’t need collateral for approval. Instead, lenders make decisions based on credit history, income, and outstanding debts. 

Unlike a car loan, a mortgage, or other secured loans, with an unsecured loan, a lender can’t repossess your belongings if you fail to pay. But there are repercussions to not paying these loans, which could involve a lawsuit or a hit on your credit. 

If you’re considering an unsecured loan, you need to understand what an unsecured loan is, how they work, and how you can use them. 

What Is an Unsecured Loan?

Both secured and unsecured loans are available through credit unions and banks. 

A secured loan, also known as an asset-backed or collateral loan, is available for various financing options, including mortgages, vehicle loans, home equity lines of credit, and certain personal loans. The lender puts a lien on collateral until you satisfy the debt. If you fail to pay your loan, the lender may seize your assets to recoup its losses.

Unsecured loans, sometimes called good-faith or signature loans, are loan types without collateral from the borrower. Instead, the lender decides whether you receive the loan based on your creditworthiness and the borrower’s promise to repay. Some personal loans, student loans, and credit cards are unsecured loans. 

Since unsecured loans aren’t backed by collateral, they are processed faster than secured loans. Lenders will look at the borrower’s income, savings, and debt to determine eligibility. But the lender takes more risks and has nothing to repossess if the borrower stops making payments and defaults on the loan. 

Due to the added risk, borrowers will need a higher credit score and a more robust payment history than with a secured loan. Lenders know recouping their money can be time-consuming and difficult. To offset the risk, interest rates and terms for unsecured loans are typically less favorable than secured loans. 

Different Types of Unsecured Loans

Each unsecured loan type provides a way to borrow money you’ll repay over time, but they all work differently.

Common unsecured loans are:

• Personal Loans. Personal loans are the most common unsecured loans used for everything from paying for vacations and weddings to financing home renovations or major purchases. Personal loans have fixed repayment terms and interest rates, which are lower than those of credit cards.
• Student Loans. Student loans are offered as federal and private. Federal loans offer lower interest rates and are available to every student attending participating colleges. Private lenders offer loans with higher interest rates and stringent requirements. 
• Credit Cards. Credit cards are revolving loans with variable limits and no set payoff date. Cardholders can spend up to the credit limit, pay off the balance over time, and use it again as needed. Users are charged interest on any outstanding balance.
• Debt Consolidation Loans. Debt consolidation borrowers take out a loan large enough to cover the balances of what they want to consolidate. Combining multiple payments into one simplifies the process, and borrowers benefit from a lower interest rate and a more favorable repayment period. 
• Medical Loans. A medical loan is used for healthcare expenses that insurance doesn’t cover. It differs from regular personal loans due to their focus on medical situations. They provide a means to handle unexpected medical costs without putting a strain on savings or credit cards.

What Lenders Look for in Unsecured Loan Borrowers

Lenders want to ensure you can repay the loan. They will weigh various financial markers to decide on your loan. 

Lenders will look at:

• Credit Score and History. Your credit score, usage, and history are the most significant determining factors during the unsecured loan approval process. Lenders want to see how you’ve managed prior loans and credit cards. They’ll look for a history of on-time payments, low credit card balances, and a mix of accounts, with at least two years of credit history. They’ll look for a credit score between 610 and 640 to qualify, with a score of 720 or higher to receive the most competitive rates. 
• Income and Job History. The lender wants to ensure you can comfortably repay the loan. A stable employment history shows you have financial stability, which gives lenders confidence that you have the means to repay. You’ll be asked to provide recent pay stubs.
• Debt-to-Income Ratio. Lenders want to see how much of your income currently goes to servicing your existing debt. Every lender has different requirements. Ideally, lenders want a debt-to-income ratio of 36% or less.

Is an Unsecured Loan a Good Fit?

Choosing between a secured and unsecured loan will depend on what you need the money for, how quickly you need it, and your loan qualifications. 

How much flexibility do you need? Do you need to bridge short-term income gaps or cover temporary financial setbacks? Are you looking to consolidate your debt? Unsecured loans might be a good option. A secured loan can make more sense if you’re purchasing an asset like a car or house.

Only borrow what you can afford to pay back. This sounds like common sense, but it’s often overlooked. Your financial situation — credit score, income, employment status — will weigh into the decision on the type of loan and loan terms. 

How the Application Works for an Unsecured Loan

Ready to get started? The application process for an unsecured loan is straightforward. Still, there are a few essential steps to receive an unsecured loan. 

• Step 1: Check Your Credit Score. You will need a credit score between 610 and 640 to qualify; the most competitive rates are reserved for a FICO score of at least 720. Use a free online service to check your credit score before you apply. You can check your score annually at no charge from the three credit bureaus: Equifax, Experian, and TransUnion. Not only will this help you anticipate your likelihood of approval, but checking your score also allows you to improve it before you submit your loan application. Check and correct any incorrect information, such as incorrectly reported delinquencies or the same debt listed more than once. These errors could be dragging down your score.
• Step 2: Evaluate Your Budget. Evaluate your income and expenses. Lenders will consider a borrower’s debt-to-income ratio (DTI) when reviewing their loan application. Lenders look for a DTI of 36% or less to qualify for a new unsecured loan. You want to ensure you can take on the loan debt before proceeding. 
• Step 3: Shop for Lenders and Prequalify. Start shopping for lenders offering the most competitive APRs and flexible repayment terms. Many lenders offer pre-qualification, a short process where you provide your basic personal information and financial details, and receive a preview of the loan you may receive within minutes without impacting your credit score. 
• Step 4: Gather Documentation. Collecting necessary documentation, such as tax returns or W-2s, your Social Security Number, and expenses like mortgage or rent payments, before applying can speed up the process.
• Step 5: Submit an Application. Complete a loan application and submit it. Many lenders now offer an online application process as well as quick approval times and same- or next-day funding. 

Once approved, the bank disburses funds as a lump sum, and interest begins accruing. You repay in equal monthly installments until the balance is paid. 

Positives and Negatives to Keep in Mind

The most apparent advantage of an unsecured loan is that you don’t need any collateral to apply. You’re not risking losing the collateral if you cannot repay the loan, and you won’t have to wait for an appraisal to determine the value of your asset.

With unsecured loans, you benefit from: 

• Fast Funding. You can complete the application for an unsecured loan in minutes. You could have approval as soon as the day you apply, with an average of three business days.
• Flexible Use. Unsecured loans have fewer borrowing restrictions, and you can use them for various purposes. Use it to consolidate debt, moving costs, emergency funds, or really whatever you want. 
• Predictable Payments. Unlike credit cards, unsecured loans offer fixed-term rates, making it easier to predict and budget. And when you make on-time payments, you can boost your credit score, opening financial doors down the road. 

But like any loan, unsecured loans have financial repercussions to be aware of before you commit: 

• Credit Risk. If you default on an unsecured loan, it will impact your credit score. A missed payment greater than 30 days will drop your credit score and stay on your report for up to seven years. 
• Higher Interest Rates. Unsecured loans typically have higher interest rates; the exact amount varies based on your creditworthiness. FICO scores at 669 or lower face higher rates or difficulty getting a loan.
• Lower Loan Limits. Except for student loans, unsecured loans usually have lower borrowing limits. Check the terms of a loan before you sign.

Let TFFCU Make Your Unsecured Loan Simple and Stress-Free

You’ll want to weigh the risks and rewards of any loan. Unsecured loans are an excellent financing option if you want to avoid offering up collateral but have good credit and a reliable income. But before considering any loan, review the terms and interest rates carefully. You’ll want to consider your unique situation and ability to repay the loan. 

The Focus Federal Credit Union’s unsecured loan options include local, not-for-profit service and a member-first mindset. We offer more flexible lending than traditional banks with friendly guidance from a local team, helping you with education and financial success. Contact us today to learn more about what an unsecured loan is and if it’s the best option for you.

Aiden Ferguson

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