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An unsecured personal loan is a type of loan that you can take out to pay for almost anything. Because you don't need to offer the lender collateral on an unsecured loan, you won't put your assets at risk if you need to borrow money to pay for a major expense, such as a wedding or medical emergency, or to consolidate high interest credit card debt. That luxury could come at a price, however. Read on to find out whether an unsecured personal loan may be right for you.
How Unsecured Personal Loans Work
An unsecured personal loan works similar to other types of loans. You apply for a personal loan from a lender, such as a bank, credit union or online lender. The lender will review your application and likely check one of your credit reports and scores.
Based on your creditworthiness, the lender will either approve or deny your application. If it approves your application, the rates and terms you're offered can depend on your creditworthiness and the amount of money you want to borrow.
If you're taking out a loan for a specific purpose, such as consolidating credit card debt, the lender might be able to send the money directly to the card issuers. But generally, the loan is sent to your account. You'll have to start repaying the loan once it's disbursed.
Unsecured loans sometimes have restrictions in the loan agreement that forbid you from using the money for certain activities, such as starting a business, investing or paying educational expenses. But generally, you can use the money for anything else.
Some choices may be more financially sound than others, though. For example, consolidating credit card debt can help you save money and lower your monthly bills. But taking out a large loan to pay for a vacation might leave you with the financial blues once you're back home and making payments.
How Unsecured Loans Differ From Secured Loans
You may be able to apply for a secured personal loan rather than an unsecured personal loan. The big difference is that you must provide the lender collateral when you take out a secured loan. Your collateral is what "secures" the loan, and if you stop making payments, the lender can take the collateral to cover your debt.
With an auto loan or mortgage, two types of secured loans, the car or home is collateral for the loan. Title loans and pawn shop loans are two additional types of secured personal loans; these loans typically come with high interest and onerous terms, so borrowers usually turn to them as a last resort.
You can sometimes secure a loan with cash rather than property. For example, a credit-builder loan is a secured installment loan that uses money set aside in a savings account or CD as collateral while you pay off the loan. It could be a good option if you're looking to build credit for the first time.
Advantages of Unsecured Personal Loans
There are several reasons you may want to take out an unsecured personal loan rather than borrow money another way:
- They're often installment loans with a fixed interest rate, which can make it easier to plan and budget around.
- Depending on your creditworthiness, you could borrow a large amount of money without putting your personal property at risk.
- You may get approved for a lower interest rate than you could with other types of unsecured loans, such as a credit card.
- You can usually choose from different terms to alter the monthly payment.
- You can use the money to pay for a variety of expenses.
Drawbacks of Unsecured Personal Loans
An unsecured personal loan isn't always the best fit, though:
- Even for those with good credit, unsecured loans tend to have higher interest rates than secured loans.
- You might not get approved for as much money as you want to borrow.
- If you don't have good credit or a high income, you may only get approved for an unsecured loan with a high interest rate.
- Some lenders charge origination fees on unsecured loans, which can be 1% to 6% of the loan amount.
How Unsecured Personal Loans Can Affect Your Credit
As with other types of installment loans, applying for and taking out an unsecured personal loan can impact your credit in several ways:
- Applying for an unsecured loan will add a hard inquiry to your credit report, which could hurt your credit scores, even if your application is denied. Hard inquiries stay on your report for two years, but their impact on your scores decreases over time.
- If you're approved, the lender will typically report your new loan and payments to the credit bureaus. This can be a good or bad thing for your credit, depending on how you manage your payments.
- If you don't already have an installment loan in your credit history, the personal loan may add to your credit mix (your experience managing different types of credit accounts), which could improve your scores.
- As you repay the loan, your on-time payments could build a positive credit history and improve your scores. However, making late payments or letting your loan go delinquent will likely hurt your scores.
- If you use the personal loan to consolidate credit card debt, you can lower your credit utilization rate, or amount of available credit you're using, which may improve your scores.
How to Qualify for an Unsecured Personal Loan
Your creditworthiness can be particularly important when you're applying for an unsecured personal loan because the lender is offering you the money based solely on your promise to repay the debt.
Generally, your application will be evaluated based on:
- Your credit history: Lenders use your credit reports to learn how long you've been utilizing credit and whether you've paid your bills on time. If you're not sure what your credit history looks like, you can check your Experian credit report for free.
- Your credit scores: Lenders also consider your credit scores and may have a minimum credit score requirement. If your scores don't fall in the good to excellent ranges, consider trying to improve your credit scores before applying if you don't need a loan right away.
- Your debt-to-income (DTI) ratio: Your DTI ratio shows how your monthly income compares to your monthly bills. Lenders want to make sure you have enough income to cover your bills and repay the loan. Increasing your income and paying down debts can improve your DTI.
Some lenders focus on specific types of borrowers, such as those with high incomes and excellent credit or those who've had credit troubles in the past. But even within the same group, each lender may have its own criteria for evaluating an application.
Lenders often publish some of their criteria online and advertise their interest rate range as well as minimum and maximum loan amounts. Comparing lenders and reviewing this information can help you determine which lender might be a good fit.
Sometimes you can apply for a preapproval, which will result in a soft inquiry (the type that doesn't hurt your credit scores) and could give you a sense of whether you'll get approved and your potential rate. But you'll generally still need to submit a complete application, and agree to a hard inquiry, before you receive an official loan offer.