Sometimes learning about money can feel like learning a new language.
At some point in your financial education, you might’ve seen the terms “secured loans” and “unsecured loans” and wondered what they mean.
Although they serve the same purpose — giving you money you don’t have — there are many differences between secured and unsecured loans.
What are unsecured loans?
The best way to explain an unsecured loan is to first describe its opposite: a secured loan.
Secured loans require “collateral” — something the bank can take if you fail to make payments. Well-known examples of secured loans include mortgages and car loans.
With an unsecured loan, on the other hand, there’s no collateral. If you don’t make your payments, the lender has to sue you for the money or sell your debt to a collection agency.
There are two types of unsecured loans:
- Revolving: Like credit cards and personal lines of credit, these loans can be paid down and then spent again.
- Term: Like peer-to-peer, student, and personal loans, these loans are for a set duration and monetary amount.
In this post, I’ll focus on personal loans — the broadest type of term unsecured loan.
Although lenders might ask what your personal loan is for, you can take one out for any reason: to buy a new dress, do home improvement projects, or go on a trip.
Because there’s no collateral, lenders will examine your credit history and debt and income levels and often perform a background check to determine if you qualify for the loan.
5 pros of unsecured loans
Now that you know what unsecured loans are, let’s go over the benefits.
1. You know the exact payments you’ll owe
If you take out an unsecured personal loan, you’ll know your monthly payments and repayment term upfront.
Most personal loans are available with terms between two and five years, and since most have fixed interest rates, there won’t be any surprises when it comes to paying the bill each month.
2. Quicker approval time
If you’ve ever applied for a mortgage, you know it’s not an easy process.
Because unsecured loans don’t involve collateral, the application and approval process often moves more quickly.
At LendingClub, for example, the application, approval, and funding process takes approximately seven days.
3. It can improve your credit score
Little-known fact: If you use a personal loan to pay off a credit card, it can increase your credit score.
That’s because paying off a credit card decreases your credit utilization ratio — the amount of available credit you’re using — which is a boon for your score.
4. More freedom
With an unsecured personal loan — or a credit card, for that matter — you’re free to use the money however you wish. Secured loans, on the other hand, require you to purchase a specific item with the money you receive.
While purchasing things you don’t need on credit generally isn’t a good practice, there is one financially savvy use of unsecured personal loans: paying off high-interest credit card debt.
If you can get a personal loan at a lower interest rate than your credit card, it could save you a significant amount of money.
Let’s say you owe $15,000 across three different credit cards that have interest rates of 22.00%, 25.00%, and 23.00%. If you paid them off with a personal loan at an interest rate of 19.00%, you’d not only have fewer payments to worry about — you’d also save $9,456 over three years.
Check your own numbers with our credit card consolidation calculator.
5. Fewer immediate consequences of default
Although you should never take out a loan if it’s likely you’ll default, unsecured loans have fewer immediate consequences if you don’t pay.
When you don’t pay your mortgage or auto loan, you risk losing the roof over your head or the wheels that get you to work. But when you default on an unsecured loan, the bank doesn’t have anything to take away.
Instead, it must sue you or send your loan to a collection agency. That’s far from a good thing, though; eventually, it will negatively affect your credit and could even lead to garnished wages.
3 cons of unsecured loans
Although unsecured loans have benefits, there are some drawbacks you need to know about.
1. Higher interest rates
Because there’s no collateral, banks need to make their investments worthwhile. So unsecured loans have higher interest rates than secured loans.
For people with average credit (640 to 679), the average personal loan APR is between 17.80% and 19.90%, according to ValuePenguin.
If you have solid credit, then a zero-interest credit card might be a better option. Just make sure you pay the balance in full before the promotional period ends.
2. More difficult to obtain
Again, because there’s no collateral, lenders need to minimize the risk they accept — which they do by limiting unsecured personal loans to people with good credit.
In fact, if your credit score is below 580, you probably won’t find a personal loan that “makes financial sense,” according to Debt.org.
You can explore personal loans for people with fair credit or try improving your score with a credit builder loan. Alternatively, apply at your local credit union, which might be more willing to look at your complete financial picture than a big bank.
3. Lower borrowing limits and terms
Unlike a mortgage, which can run hundreds of thousands of dollars, personal loans have lower limits.
The terms are also shorter. Whereas you could pay back a mortgage over the course of 25 years, most personal loans have terms between two and five years — which means much higher payments than you’d have with a longer-term loan.
Where to apply for unsecured loans
It pays to shop around for unsecured personal loans. Check rates at major banks, credit unions, and online institutions.
And whatever you do, watch out for scams. Any lender that wants to charge you an application fee or claims you can get preapproved for a loan is one to avoid.
Here are a few factors you can use to compare lenders:
- Annual percentage rate (APR): When it comes to interest, lower is better.
- Loan terms: Lenders offer different loan terms — most between two and five years. While a longer term will lower your payments, you’ll end up paying more in interest.
- Fees: Compare origination, prepayment, and late payment fees.
- Customer reviews: Look at Trustpilot or Credit Karma to see if customers are happy with the lender.
For a few of the banks we recommend, check out the list below.
Interested in a personal loan?
Here are the top personal loan lenders of 2018!
|7.39% – 29.99%||$1,000 – $50,000||VISIT UPSTART|
|5.29% – 14.24%1||$5,000 – $100,000||VISIT SOFI|
|8.00% – 25.00%||$5,000 – $35,000||VISIT PAYOFF|
|5.99% – 16.24%2||$5,000 – $50,000||VISIT CITIZENS|
|5.99% – 35.89%||$1,000 – $40,000||VISIT LENDINGCLUB|
|5.25% – 14.24%||$2,000 – $50,000|