What is an Unsecured Loan?
An unsecured loan is a loan that is issued and supported only by the borrower's creditworthiness, rather than by any type of collateral. Unsecured loans—sometimes referred to as signature loans or personal loans—are obtained without the use of property or other assets as collateral. The terms of such loans, including approval and receipt, are therefore most often contingent on the borrower's credit score. Borrowers must generally have high credit ratings to be approved for certain unsecured loans.
How an Unsecured Loan Works
An unsecured loan stands in direct contrast to a secured loan, in which a borrower pledges some type of asset as collateral for the loan, in turn increasing the lender's "security" for providing the loan. Unsecured loans are bigger risks for lenders, and as a result, they typically have higher interest rates and require higher credit scores than secured loans, such as mortgages or car loans. In some instances, lenders will allow loan applicants with insufficient credit to provide a cosigner, who can take on the legal obligation to fulfill a debt should the borrower default.
Types of Unsecured Loans
Unsecured loans include credit cards, student loans, and personal loans—all of which can be revolving or term loans.
- A revolving loan is a loan that has a credit limit that can be spent, repaid, and spent again. Examples of revolving unsecured loans include credit cards and personal lines of credit.
- A term loan, in contrast, is a loan that the borrower repays in equal installments until the loan is paid off at the end of its term. While these types of loans are often affiliated with secured loans, there are also unsecured term loans.
- A consolidation loan to pay off credit cards or a signature loan from a bank would both be considered an unsecured term loan.
There's ample data to suggest that the unsecured loan market is growing, powered partly by new financial technology. In a December 2018 consumer credit report, TransUnion projected that credit card balances in the United States would rise 4% in 2019 to $840 billion while personal loan balances are expected to climb 20% and reach an all-time high of $156.3 billion by the end of this year.
The past decade has seen the rise of peer-to-peer lending via online and mobile lenders, coinciding with a sharp increase in unsecured loans. In another report, TransUnion found that "fintechs," or financial technology firms, accounted for 40% of personal loan balances through the first quarter of 2018, up from just 8% in 2013.
[Important: Because they are riskier for lenders, unsecured loans typically have higher interest rates and require higher credit scores than secured loans.]
An Unsecured Loan vs. a Payday Loan
Alternative lenders, such as payday lenders or companies that offer merchant cash advances, do not offer secured loans in the traditional sense of the phrase. Their loans are not secured by tangible collateral as mortgages and car loans are. However, these lenders take other measures to secure repayment.
In particular, payday lenders require that borrowers give them a postdated check or agree to an automatic withdrawal from their checking accounts to repay the loan. Many online merchant cash advance lenders require the borrower to pay a certain percentage of online sales through a payment processing service such as PayPal. These loans are considered unsecured even though they are partially secured.
Special Considerations for an Unsecured Loan
If a borrower defaults on a secured loan, the lender can repossess the collateral to recoup the losses. In contrast, if a borrower defaults on an unsecured loan, the lender cannot claim property. However, the lender can take other actions, such as commissioning a collection agency to collect the debt or taking the borrower to court. If the court rules in the lender's favor, the borrower's wages may be garnished, a lien may be placed on the borrower's home or the borrower may be otherwise ordered to pay the debt.