What Are Unsecured Loans?

Definition and Examples of Unsecured Loans

An unsecured loan is one that doesn't require collateral or a security deposit. With an unsecured loan, instead of pledging assets, borrowers qualify based on their credit history and income. Lenders do not have the right to take physical assets—such as a home or vehicle—if borrowers stop making payments on unsecured loans. You promise to repay, but you don’t back up that promise by pledging collateral.

• Alternative names: Signature loan, good faith loan

A few examples of types of unsecured loans include:

• Personal loans
• Student loans
• Unsecured 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

The fundamental difference between unsecured and secured loans is the need for collateral. When you apply for a secured loan, you must put up an asset—whether your home, car, investments, or cash—to receive it. In case you default on the loan, the collateral can be used to pay the lender. Secured loans are commonly used with mortgages and auto 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.