What is an Unsecured Loan?
Where a loan is granted without any need of security or guarantee by another party, or collateralized asset, which is supported by borrower’s creditworthiness and annual income, it is known as unsecured loan, which are generally issued to relatives and family members of sister concerns and hence it is issued at lower or no interest rates.
Example of an Educational loan
Let’s say that you have been doing a job for a few years after graduation. Now you feel that it is the right time to go ahead and get an MBA degree. You have some savings, but that’s not enough to study in the top-notch MBA institute. So you go to a bank and talk to them about an education loan. They tell you that up to a certain extent, the bank will offer you a loan that doesn’t need any collateral. But if you take more amount than that you would need to keep collateral against the educational loan that you would want to take.
You talk to your parents and they tell you that they will offer you a portion of the money. And after calculating, you find out that you can take an unsecured loan from the bank and the rest of the amount you can pay from your savings and from your parents’ savings.
This is how it works. We will take another example to see another side of an unsecured loan.
Example of Credit Card Loan
Credit cards are one of the unsecured loans. We don’t know it when we start to use it, but credit cards are actually one type of unsecured loan.
While issuing the credit card, the credit card company or the financial institution set a limit for your usage. And they also give you a time limit to pay off the amount.
If you remain within the limit and you pay off the amount within the stipulated time, you need to only pay the interest as it is prescribed. But if you default or don’t pay off within the time limit, the interest rate and the whole amount due get increased day by day. And after a year or so, you would see a huge amount looming large in front of you and you wouldn’t find a way to pay off.
How is Unsecured Loan Given?
An unsecured loan isn’t secured as the name suggests. That’s why the financial institution/bank has to check a few things about the borrower. Here are the things they check before offering them the unsecured loan –
- Character: This is an intangible thing, but the bank/financial institution checks whether the borrower has a history of default or not.
- Capacity: Then they check whether the borrower has the financial capacity to pay off the loan.
- Collateral: Then the financial institution/bank checks if the borrower defaults whether the bank can sell off any collateral of the borrower and claim the amount.
- Conditions: Lastly, they look at the conditions of the borrower so that they can know whether this person can pay off the money offered to him in the future.
After being ensured about these four things, the bank/financial institution offer an unsecured loan to the borrower. These four things help the financial institution decide the credit-worthiness of the borrower.
Important features of Unsecured Loan
There are a few characteristics that are keys in the case of unsecured loans –
- No collateral: For unsecured loans, there is no collateral required. That’s why for a short-term loan or small amount, the borrower can think of an unsecured loan.
- The creditworthiness of the borrower is important: Since the lender doesn’t have any backing in offering the loan, the creditworthiness of the borrower is so very important. And before offering any amount, the bank/financial institution first checks whether the person taking the loan has the creditworthiness to pay off the amount in the near future.
- Higher interest rate: Since there’s no backing for an unsecured loan, the interest rate is much higher than the interest rate for the secured loan.
- Smaller amount: In the case of an unsecured loan, usually, the amount is much smaller. Every bank/financial institution has a limit till which they will offer a loan without any collateral. If the borrowers need to borrow more money, s/he has to produce collateral against the loan amount.
- Great personal loan: Unsecured loans can be great personal loans as well. If you need money immediately and can’t take from anybody around, you can go to the bank and ask for a personal loan. If the bank finds you to be a good fit in the scale of credit-worthiness, they will offer you a loan without any collateral.
This has been a guide to an unsecured loan. Here we discuss the definition and important features of unsecured loans along with practical examples. You may also learn more about fixed income from the following recommended articles –