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 approved 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. Typically, borrowers must have high credit scores to be approved for certain unsecured loans. A credit score is a numerical representation of a borrower’s ability to pay back debt and reflects a consumer’s creditworthiness based on their credit history.
- An unsecured loan is supported only by the borrower’s creditworthiness, rather than by any collateral, such as property or other assets.
- Unsecured loans are riskier for lenders than secured loans; as a result, they come with higher interest rates and require higher credit scores.
- Credit cards, student loans, and personal loans are examples of unsecured loans.
- If a borrower defaults on an unsecured loan, the lender may commission a collection agency to collect the debt or take the borrower to court.
How an Unsecured Loan Works
An unsecured loan stands in contrast to a secured loan, in which a borrower pledges some type of asset as collateral for the loan. The pledged assets increase the lender’s “security” for providing the loan. Examples of secured loans include mortgages or car loans. Unsecured loans, because they are not backed by pledged assets, are riskier for lenders, and, as a result, typically come with higher interest rates. Unsecured loans also require higher credit scores than secured 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, which occurs when a borrower fails to repay the interest and principal payments of a loan or debt.
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 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. The past decade has seen the rise of peer-to-peer lending (P2P) via online and mobile lenders, which coincides with a sharp increase in unsecured loans. In its “Q4 2018 Industry Insights Report,” TransUnion found that fintechs (short for financial technology firms) accounted for 38% of unsecured personal loan balances in 2018, up from just 5% in 2013. Banks and credit unions saw a decline in shares of personal loan balances in the same period.
The amount of U.S. consumer revolving debt as of December 2019. This represents an increase of 14% on an annualized basis.
Source: Federal Reserve data.
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 in the way that mortgages and car loans are. However, these lenders take other measures to secure repayment.
Payday lenders, for example, 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 any 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. Also, a lien may be placed on the borrower’s home, or the borrower may be otherwise ordered to pay the debt.