Are Unsecured Loans a Good Idea?

Are Unsecured Loans a Good Idea? article image.

Major expenses like a home remodeling project, your daughter's wedding or an unexpected tax bill may cost more than you have in your savings account. Could taking out a personal loan be the answer? Getting an unsecured personal loan may be a good idea if it's financing a move that will ultimately save you money, such as paying off high-interest credit card debt. But before you apply for an unsecured loan, it's important to understand the benefits and risks, as well as potential alternatives to borrowing.

What Is an Unsecured Personal Loan?

You can get unsecured personal loans from banks, credit unions, online lenders and through peer-to-peer lending platforms. Typically, personal loans can be used for any purpose you choose, although some do have restrictions placed on them. After you apply for the loan and provide the necessary financial information, your application will be approved or denied depending on your creditworthiness and other factors.

An unsecured personal loan is a type of installment credit, meaning you repay it over a set amount of time by making a certain number of fixed monthly payments. You'll typically need to start making payments on the loan as soon as you receive the proceeds. In most cases, the lender will disburse the money directly to you; however, if you're getting the loan to pay off credit card debt, the lender may send the money directly to the credit card companies.

If you don't already have an installment loan such as a student loan or car loan, getting an unsecured personal loan and making payments on time can have a positive impact on your credit scores by enhancing your credit mix. Credit mix, which refers to the variety of credit types you have, counts for 10% of your FICO® Score .

Unsecured vs. Secured Personal Loans

There are two broad types of personal loans: secured and unsecured. To get a secured loan, you must pledge collateral—something of value that the lender can take if you don't pay the loan. Mortgage loans and auto loans are common types of secured loans. With these loans, the home or car you're financing acts as the collateral; if you default on the loan, the lender will foreclose on your house or repossess your car. For a secured personal loan, the lender might ask you to pledge collateral such as real estate, investment or bank accounts, insurance policies, or valuables such as art or antiques.

Because the lender has collateral to fall back on if you default on the loan, secured loans pose less risk for lenders. This can make it much easier to get a loan with less-than-stellar credit. Secured loans may give you access to higher loan amounts, along with lower interest rates and better terms than unsecured loans.

The big downside of a secured loan, of course, is the risk of losing your collateral if you can't pay the loan.

Unsecured personal loans also have their own pros and cons. Because the lender is shouldering a bigger risk, you'll probably pay more interest than you would for a secured loan, and you may not be able to borrow as much money. You'll also need better credit to get an unsecured loan than a secured loan.

The big upside of an unsecured loan? You can get the money you need without jeopardizing your home or other assets.

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What Happens if You Default on an Unsecured Loan?

Missing payments and defaulting on an unsecured loan won't cost you any collateral, but it tends to have a major impact on your credit. Because your payment history is the biggest factor in your credit score, missing even one loan payment can significantly affect your credit score.

When you miss a payment, the lender will notify you—typically more than once—and may give you a 30-day grace period to bring your account current. If you fail to do so, eventually the lender will send your account to their in-house collections department or transfer it to a third-party collection agency. At that point, the past-due payment is reported to credit bureaus and shows up on your credit report.

The lender will try to get payment from you one way or another, and may even resort to filing a lawsuit to collect payment. Once your debt is in collections, your original account with the lender may show up on your credit history as a charge-off, indicating that the lender hasn't been able to collect from you and has given up. Your collection agency account will appear on your credit report as a separate account.

Collection accounts stay on your credit report for seven years from the original delinquency date, even if you pay off the debt. Having an account in collections is a serious negative mark on your credit report that can drag down your credit scores and make it harder to get approved for credit in the future, or cause you to be charged a higher interest rate.

Alternatives to Unsecured Loans

If you're having trouble getting an unsecured personal loan, there are several alternatives to consider.

  • Get a secured personal loan. If you haven't established a credit history or are trying to rebuild poor credit, it can be tough to get an unsecured personal loan. A secured personal loan could provide the money you need. If you're looking for a lower interest rate than an unsecured personal loan offers, a secured personal loan may cost less. Just keep in mind that if you default on a secured personal loan, you'll not only damage your credit, but also lose your collateral. Review your budget carefully before applying for a secured personal loan to be sure you can manage the payments.
  • Borrow from friends or family members. Sometimes the best place to look for money is close to home. Do you have friends or family members who can lend you the money you need? If so, be sure to put the loan in writing, just as you would with a bank loan, and take repayment seriously. Otherwise, the collateral you lose could be your relationship.
  • Use a credit card. A credit card could provide the money you need for a major expense or even help you pay off high-interest credit card debt. If you can find a credit card that offers a 0% introductory APR on purchases or balance transfers, you can transfer a high-interest credit card balance to it or use it for a big purchase. Just make sure you can pay off the balance before the regular APR takes effect and interest starts racking up.
  • Set up a payment plan. Do you need a way to pay an unexpected tax, dental or medical bill? Instead of borrowing money, see if you can negotiate with the IRS, your dentist or your health care provider to make installment payments on what you owe.

Check Your Credit Before Applying for an Unsecured Loan

Taking out an unsecured personal loan can help you handle unexpected expenses or pay for big purchases. But it's important to make sure you're getting the best personal loan for your situation. Before applying for any type of personal loan, review your credit report and scores to see where you stand. If you have good credit, you're more likely to be approved for an unsecured personal loan, so you can get the money you need without risking any of your assets as collateral.