Unsecured Loan Meaning
An unsecured loan is a loan extended without the need for any collateral. It is supported by a borrower’s strong creditworthiness and economic stability. If borrowers default on the loan, they can face strict actions like a poor loan credit score, collection agents or legal actions.
- An unsecured loan is a facility to acquire loans using one’s outstanding credit score, without pledging any collateral like a house or car. Personal loans, credit cards, student loans are some examples of uncollateralized loans.
- These loans are popular as they can be acquired for personal reasons such as home renovation, foreign trip, and medical bills, among others.
- The interest rates are usually higher than secured loansSecured LoansSecured loans refer to the type of loans approved and received against a guarantee or collateral. If they fail to do so, the lending institution acquires the collateral to compensate for the amount that the borrowers were allowed. to compensate for no collateral requirement and because one cannot rely upon a security in case the borrower defaults.
- The application process of unsecured loans is less complicated especially with the entry of many online players. However, a borrower needs to have a good credit score, and stable income to be able to convince the lender being worthy of acquiring the loan.
Table of contents
Understanding Unsecured Loans
Unsecured loans get their popularity for allowing relatively easy financial assistance to borrowers with distinct personal needs like planning a trip abroad. One can borrow small amounts without pledging a belonging. As opposed to the alternative like payday loans, these loans charge relatively lesser interest rates. Moreover, many online lenders of unsecured loans transfer the credit in just a day, adding more convenience.
Credit unions, many banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. offer these loans. The procedure is fairly standard. It involves specifying the loan terms, forms, authentication of borrower’s documents and loan extension. However, whether one would be granted an unsecured loan or not relies heavily on their creditworthiness.
Financial lending is endowed with the default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.. The lender can recover the borrowed sum in a secured loan by selling the borrower’s pledged borrowing, but an unsecured loan has no such facility. Therefore, a person with low creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan. will not receive the loan in most cases due to high chances of default.
If the borrower misses installments, lenders can approach debt collectorsDebt CollectorsA debt collector is a person or company hired by a business to track and recover debt owed on sales of goods and services that exceed accepted payment terms. Internal debt collectors, third-party debt collectors, and debt buyers are the most common types of debt collectors. who’d try to recover the debt. They can sue the debtorDebtorA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. under which recourse such as wage garnishment is common. Additionally, many debt collectors have harassed debtors in the past. Debtor protection laws such Fair Debt Collection Practices Act (FDCPA) comes to their rescue in such cases.
Features of Unsecured Loan
We have already discussed the importance of creditworthiness in these loans; let us take you through other essential characteristics for better clarity on the topic.
- Higher interest rate: As compared to secured loans, the interest rate is much higher for uncollaterized loans to compensate for not asking collateral. Normally, unsecured loans come with an interest rate ranging between 5-36%. Since personal loans usually come with high interest rates, having a good creditworthiness is believed to help one secure less expensive rates.
- Smaller amount: The loan amount is usually smaller, likely between $1,000 to $100,000. Every bank/financial institution has a limit till which they will offer a loan without any collateral. If borrowers need to borrow more money, they will need to produce collateral against the loan amount.
- Tenure – Repayment can occur in installments or lump sump. Usually the maturity tenure is 4-6 years.
Borrowers should compare rates, fees, penalties for missed payments, be sure of repayment capabilities and credit score, etc., before deciding on the lender. Many banks allow negotiating the rates of interest. Moreover, many online firms help borrowers get personal loans by bridging the gap between loan seekers and loan granters.
Let us take you through major examples or types of unsecured loans.
1. Personal loans
Unsecured loans can be great personal loans as well. For example, if you need money immediately and can’t take it 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 on the scale of creditworthiness, they will offer you a loan without any collateral.
People can borrow them for personal reasons, such as a medical emergency, a short-notice trip, renovations, etc. Some banks also offer credit facilitiesCredit FacilitiesCredit Facility is a pre-approved bank loan facility to businesses allowing them to borrow the capital amount as & when needed for their long-term/short-term requirements without having to re-apply for a loan each time. to pay credit card debt. In addition, many reputed US banks offer personal loans.
2. Educational/Student Loan
Educational loans are a popular example of unsecured loans since students find it difficult to finance higher studies such as a master’s degree. So you approach a bank, and they say that up to a certain extent, they can offer you a loan that doesn’t need any collateral.
But beyond that, they’d need security. So you work up the details, savings, and part-time jobs. Convinced that you’d manage the repayments, the bank then extends the loan.
3. Credit Cards
We don’t realize this as we enroll for a credit card, but it essentially is an unsecured loan. The credit card company sets a limit for your credit card usage. They also provide a time limit to pay off the credit amount. You’d only need to pay your dues within the stipulated time. However, if you don’t pay off the dues within the time limit, the company starts charging interest on the due amount.
The more you delay, the more charges continue to pile up. In fact, there have been many cases where some borrowers were constantly bothered by debt collection agents for recovery.
Loan Qualification Requirements
Financial institutions check a few things about the borrower before offering the loan to access their creditworthiness. A creditworthy borrower will minimize the chances of default on unsecured loans. The requirements are listed below –
- Character: Credit institution checks whether borrowers have a history of default or not using their credit score. Although, the acceptable score varies with banks, a credit score of over 600 makes one eligible for personal loans, while those above 750 qualify for less expensive interest rates.
- Capacity: Officials also check whether the borrower has the financial capacity to pay off the loan. A stable income that can cover off the repayment and interest amount is a must for many institutions.
- Collateral: The financial institution/bank also check if they claim the amount using any collateral if the borrower defaults.
- Conditions: They also look at the conditions of the borrower so that they can know whether this person can pay off the debt in the future or not.
- Cosigner – If a borrower’s credit score is lacking, some banks grant the loan on a third person’s gurantee for the repayment.
Student loans, personal loans and credit cards are all examples of unsecured loans. A personal loan can help fund cash requirements arising out of many sudden requirements such as home improvement, medical bills, an urgent trip abroad, etc.
A secured loan is backed with collateral which the lender holds a claim to recover the principal amount if the borrower defaults. Conversely, an unsecured loan is not backed with security and is extended based on the borrower’s creditworthiness. In case of default, the lender can take legal assistance or approach financial agents for recovery.
There are many credit institutions, banks, and online companies offering them. A borrower should compare the rates across different institutions and ensure that the repayment can happen timely to avoid attracting legal action.
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 finance from the following recommended articles –