A Guide to Unsecured Loans

An unsecured loan provides funds with no collateral required. However, it can be more difficult to get compared to other types of loans because it requires a high credit rating.

An unsecured loan is a type of loan that is not backed by any type of collateral. Banks and other financial institutions typically grant unsecured loans to borrowers who have high credit ratings and are less likely to default or breach the terms and conditions.

How Does an Unsecured Loan Work?
An unsecured loan is typically granted to borrowers who have an excellent credit score. It is considered a high risk to lending institutions as there is no asset or property, such as a house or vehicle, which serves as collateral in case the borrower defaults or fails to pay. Because it's a high-risk loan, it's typically more difficult to get and has stricter application requirements compared to a secured loan. Also, if the borrower qualifies, the loan usually carries a higher interest rate.

The borrower's creditworthiness is evaluated based on the five C's of credit: character, which refers to the borrower's reputation or track record for paying off debts; capacity, which refers to the borrower's ability to repay a loan by comparing his or her income against his or her current debts as well as calculating his or her debt-to-income ratio; capital, which refers to the amount of money the borrower puts toward a potential investment; collateral, which gives the bank the assurance that if the borrower fails to repay the loan, the bank can sell the collateral to recoup the loss; and conditions, which refers to how a borrower intends to use the money.

Examples of Unsecured Loans
Some examples of unsecured loans include personal loans, student loans and credit cards, and these loans can either be revolving or term loans. A revolving loan comes with a line of credit, which can be spent and repaid. Credit cards and personal lines of credit are some examples of a revolving unsecured loan.

A term loan, on the other hand, is a loan that has a specified repayment schedule (amortization) and a floating or fixed interest rate. Although a term loan is usually associated with a secured loan, such as a car loan and mortgage, there is also an unsecured term loan and some examples of this include a consolidation loan or a signature loan.

Secured vs. Unsecured Loans
The significant difference between a secured and unsecured loan is that collateral backs a secured loan in case a borrower defaults. If the borrower defaults on or fails to repay a secured loan, the bank can simply foreclose or repossess the collateral to regain its losses. If the borrower fails to repay an unsecured loan, however, the bank can't claim his or her property.

The bank can take other options to recover the loss. It can either commission an agency to collect the payment or file a lawsuit against the borrower. If the court rules in favor of the bank, the borrower may be forced to pay the debt. If he or she can't really pay the debt for some valid reasons, his or her wages may be seized or a lien may be placed on his or her home.