Unsecured Loan: What It Is, How It Works & How to Qualify for One
Thursday, Dec 21 2023
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. Unlike a car loan, mortgage, or other secured loan, with an unsecured loan, a lender can’t repossess your belongings if you fail to pay.
Instead, lenders make decisions based on your credit history, income, and outstanding debts. But there are repercussions to not paying these loans, which could involve a lawsuit or a hit to your credit.
If you’re considering an unsecured loan, before you apply, let’s look at how they work and how you can use them.
Definition of an Unsecured Loan
Unsecured loans, sometimes called good faith or signature loans, are loan types that don’t require collateral. Instead, the lender decides whether you receive the loan based on your creditworthiness. Common unsecured loans include personal loans, student loans, and credit cards.
Since these loans aren’t backed by collateral, the lender takes on more risk with an unsecured loan. They have nothing to repossess if the borrower stops making payments and defaults. Banks and credit unions typically charge higher interest rates and require good-to-excellent credit for these loans to account for the added risk.
If a borrower defaults, there are avenues banks and credit unions can take for repayment. Following nonpayment, the lender will send the outstanding balance to a collection agency. The lender can pursue legal action to recoup the loan balance. This action can result in wage garnishment or a lien on the borrower’s home or another asset. And when a loan account defaults, the borrower will experience a drop in their credit score, limiting future financial options.
Types of Unsecured Loans
Unsecured loans are available from banks and credit unions, and you can use them for various purposes. 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. You can use an unsecured personal loan for almost anything, from unexpected medical bills to home improvement projects and travel.
- Student Loans. Government-backed and private student loans are unsecured. Federal loans have fixed rates, while private student loans often have fixed- and variable-rate options. With a private student loan, the lender issues a lump sum, which is repaid in installments over time.
- Credit Cards. A credit card provides access to revolving unsecured credit. Cardholders can spend up to the credit limit, pay it back, and borrow again as needed.
How Unsecured Loans Work
When you apply for an unsecured loan, the lender must determine your creditworthiness. You’re subject to stricter credit requirements because there’s no collateral to back these loans. Lenders will consider your income, savings, and debt to determine eligibility.
You’ll need a higher credit score and a more robust payment history than you would with a secured loan. You can qualify for an unsecured loan with a lower score, but you may pay a higher annual percentage rate (APR). An APR determines your loan’s overall cost, including interest and any origination or fees.
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.
Pros and Cons of Unsecured Loans
If you’re considering an unsecured loan, learning the pros and cons can help determine if it’s the right fit for you.
Pros of an unsecured loan are:
- No Collateral Requirement. 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.
- Quick Application and Disbursement. You can complete the application for an unsecured loan in a few minutes. You may find out whether you qualify on the same day you apply.
- Flexible Use. Unsecured loans have fewer borrowing restrictions, and you can use them for various purposes.
Cons of an unsecured loan are:
- Lower Borrowing Limits. Except for student loans, unsecured loans usually have lower borrowing limits.
- Stricker Requirements. Lenders often impose higher credit score requirements due to increased risk.
- Higher Interest Rates. Low credit scores will result in borrowers paying higher interest rates.
Unsecured vs. Secured Loans
Both secured and unsecured loans are available through credit unions and banks. The critical difference between secured vs. unsecured is whether you pledge collateral to get the loan.
An asset backs a secured loan or collateral loan. This loan type exists 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 a debt. If you fail to pay your loan, the lender may seize the asset to recoup its losses.
Collateral-free loans still have risks. Defaulting on unsecured loans results in collection efforts, leading to adverse credit reporting and even legal action against the borrower by the lender.
To offset the risk, interest rates and terms for unsecured loans are typically less favorable than secured loans. Lenders know recouping their money can be time consuming and difficult. To limit their risk, lenders often require a higher credit score to qualify.
Qualifying for an Unsecured Loan
The application process for an unsecured loan is straightforward. Lenders want to ensure you can repay the loan. They want to measure the risk they’re taking by evaluating your creditworthiness.
To evaluate risk, the lender will look at your:
- Credit Score. Your credit score, usage, and history are the largest determining factors during the unsecured loan approval process. Lenders want to see how you’ve managed prior loans and credit cards. Many lenders require you to have at least two years of credit history. They’ll look for a history of on-time payments, low credit card balances, and a mix of types of accounts. They’ll also check your credit score. Lenders will look for a score between at least 610 and 640 to qualify. They’ll want a score of at least 720 to receive the most competitive rates.
- Income. The lender wants to ensure you can repay the loan. They’ll want proof of stable, sufficient income, such as a current pay stub.
- Debt-to-Income Ratio. Your debt-to-income ratio evaluates how burdened you already are with debt. Lenders consider your debt-to-income ratio when reviewing your application. The lower the ratio, the better. Every lender will have a different requirement, but ideally, they want a debt-to-income ratio of 36% or less to qualify for an unsecured loan.
Getting an Unsecured Loan from FFCU
It’s essential to consider 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 reliable income.
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. Contact us today to learn more about Focus Federal Credit Union’s unsecured loan options and rates.