Alternative names: Signature loan, good faith loan
A few examples of types of unsecured loans include:
Personal loansStudent loansUnsecured credit cards
Personal loans are available from banks, credit unions, and online lenders, and can be used for any purpose you see fit. Private student loans and those through the Department of Education are typically unsecured.
How Unsecured Loans Work
When applying for an unsecured loan, lenders check your borrowing history to see if you’ve successfully paid off loans in the past. Based on the information in your credit reports, a computer creates a credit score, which is a shortcut for evaluating your creditworthiness. To get an unsecured loan, you’ll need good credit. If you’ve done minimal borrowing in the past, or have bad credit because you’ve fallen on hard times in your past, it is possible to rebuild your credit over time. Consider taking steps to improve your credit score before applying for an unsecured loan. Lenders will also want to be sure that you have enough income to repay any new loans. When you apply for a loan, whether secured or unsecured, lenders will ask for proof of income. Then, they will evaluate how much of a burden your new loan payment will be, relative to your monthly income. They typically do this by calculating a debt-to-income ratio.
Unsecured Loans vs. Secured Loans
If you take out a mortgage, the home becomes the collateral. If you default on your payments, your lender can take sole possession of your home and resell it—a process known as “foreclosure.” If you fail to make payments on your auto loan, your lender will take ownership of the vehicle.
Pros and Cons of Unsecured Loans
Pros Explained
From the borrower’s perspective, the main advantage of an unsecured loan is the decrease in risk. If you receive an unsecured loan and can’t make payments, you don’t risk losing your assets; you just put your credit score at risk. For people and businesses with unsecured loans, there is also a chance that your debt will be discharged if you file for bankruptcy.
Cons Explained
Since unsecured loans don’t require any collateral, the lender takes on more risk, which generally translates to higher interest rates and less-favorable terms. While unsecured loans may be less risky for the borrower, it’s important to know how much more it could cost you over its duration. You may find that putting an asset down as collateral is more beneficial than the extra money you’ll pay in interest.
