What Is an Unsecured Loan?
An unsecured loan is a type of loan that does not require any form of collateral. Instead of using a borrower’s assets as security, lenders approve unsecured loans based on the borrower’s creditworthiness.
Examples of unsecured loans include personal loans, student loans, and credit cards.
Key Takeaways
- Unsecured Loan: These loans are supported solely by the borrower’s creditworthiness rather than collateral like property or other assets.
- Risk: Lenders perceive unsecured loans as riskier than secured loans, necessitating higher credit scores for approval.
- Examples: Credit cards, student loans, and personal loans fall under the category of unsecured loans.
- Default Consequences: If a borrower defaults on an unsecured loan, lenders may use collection agencies or legal action to recover the debt.
- Protection Laws: Legal protections prevent lenders from discriminatory practices, ensuring fair access to unsecured loans.
How an Unsecured Loan Works
Unsecured loans, also known as signature loans or personal loans, are approved without the use of property or other assets as collateral. That’s why these loans depend heavily on the credit score of the borrower.
Unsecured loans stand in contrast to secured loans, wherein a borrower pledges assets as collateral. Common examples of secured loans include mortgages and car loans.
Given the increased risk for lenders, borrowers must generally have high credit scores to secure an unsecured loan. If their credit score is insufficient, some lenders may allow applicants to provide a co-signer. In such cases, the co-signer assumes the legal obligation to repay the loan if the primary borrower defaults.
Since unsecured loans aren’t backed by collateral, they usually come with higher interest rates. However, lenders have limited options to recover their funds if the borrower defaults, which might include employing collection agencies or taking legal action.
Types of Unsecured Loans
Unsecured loans cover various types including personal loans, student loans, and most credit cards. These can further be divided into revolving or term loans.
- Revolving Loans: These loans have a credit limit that can be spent, repaid, and spent again, such as credit cards and personal lines of credit.
- Term Loans: For these, the borrower repays the loan in equal installments over a specified period. Examples include special purpose loans like consolidation loans and certain signature loans from banks.
Notably, fintech advancements have contributed to the growth of the unsecured loan market. This includes peer-to-peer (P2P) lending, where individuals can borrow money directly from other people through online platforms.
$1.295 Trillion: The U.S. consumer revolving debt as of Oct. 2023, noted by the Federal Reserve.
Unsecured loans can be quite beneficial when used responsibly. Before seeking an unsecured loan, tools like personal loan calculators can help you plan your financial obligations.
Unsecured Loan vs. Payday Loan
Although alternative lenders like payday lenders or companies offering merchant cash advances do not provide traditional secured loans, they require other measures to ensure repayment. Payday lenders, for instance, need borrowers to either give postdated checks or agree to an automatic withdrawal from their checking accounts. These loans may operate similarly to unsecured loans but can be risky, given their high interest rates and potential hidden fees.
Special Considerations
While lenders can decide whether to approve unsecured loans based on your creditworthiness, laws protect borrowers from discriminatory practices. The Equal Credit Opportunity Act (ECOA) makes it illegal for lenders to use non-creditworthiness factors such as race, color, sex, or religion when evaluating loan applications.
Although the lending landscape has become more equitable, discriminatory practices can still occur. Actions taken by regulatory bodies like the Consumer Financial Protection Bureau (CFPB) help safeguard against such issues.
Related Issues
What Is Considered Collateral?
Collateral is any item that can be confiscated to satisfy the terms of a loan. Typical forms include real estate, vehicles, and other valuable items.
Is a Co-Signed Loan Secured?
No, even if there’s a co-signer, the loan is not considered secured. If the borrower defaults, the co-signer must repay the loan—which does not involve repossessing any pledged assets.
Can Bankruptcy Eliminate All Unsecured Loans?
Bankruptcy can clear most unsecured loans except in the case of student loans. To demonstrate student loans are an undue hardship, a debtor must undergo a legal process called adversary proceeding for any chance of discharge.
The Bottom Line
Unsecured loans offer flexibility and aid in managing personal and educational expenses. However, with greater risks for both lender and borrower, assessing your financial situation is essential before accepting an unsecured loan. Borrowing more than you can repay can result in complex financial challenges, potentially including wage garnishment and lowered credit scores.
Related Terms: collateral, secured loans, creditworthiness, interest rates.
References
- National Credit Union Administration. “Personal Loans: Secured vs. Unsecured”.
- Federal Reserve Bank of St. Louis. “Revolving Consumer Credit Owned and Securitized”.
- Consumer Financial Protection Bureau. “What Is a Payday Loan?”
- Consumer Financial Protection Bureau. “The Bureau Is Taking Action to Build a More Inclusive Financial System”.
- Federal Register. “Request for Information on the Equal Credit Opportunity Act and Regulation B”.
- Federal Student Aid. "(Gen-23-13) Undue Hardship Discharge of Title IV Loans in Bankruptcy Adversary Proceedings".
