Can You Explain An Unsecured Loan

Dec 07, 2023 By Susan Kelly

Unsecured loans don't need any sort of security to be approved. Lenders approve unsecured loans without taking collateral in the form of property or other items. Personal loans, student loans, and credit cards are unsecured loans.

Mechanisms Of An Unsecured Loan

Unsecured loans, also known as signature loans or personal loans, don't require any kind of security to get accepted. Borrowers' credit scores are frequently used to determine loan terms, such as approval and funding. Unsecured loans often need good credit ratings from customers before approval. 1

Contrast this with a secured loan, in which the borrower must use security as an asset. The "security" for the loan the lender provides is bolstered by the collateral pledged. Mortgages and auto loans are common types of secured loans.

Lenders may accept cosigners from borrowers with poor credit ratings to grant them access to unsecured loans, despite the higher credit score requirements of unsecured loans compared to secured loans.

Different Varieties of Unsecured Loans

Personal loans, student loans, and most credit cards fall under unsecured loans. A revolving loan is a line of credit that can be borrowed, paid back in full, and then used again. Credit cards and personal lines of credit are two common forms of unsecured borrowing.

On the other hand, a term loan is paid back over a set period by uniform monthly payments made by the borrower. There are both secured and unsecured options for term loans, despite the common association between the two. Unsecured term loans include credit card debt consolidation loans and signature loans from banks.

Comparing Unsecured Loans to Payday Loans

Payday lenders and merchant cash advance providers are examples of non-traditional lenders that do not provide secured loans. These are unsecured loans compared to loans for things like homes and cars.

These lenders, however, employ alternative strategies to ensure payback. For instance, lenders in the payday lending industry often insist on either a postdated check or an agreement for automated payments from the borrower's bank account.

A common stipulation of online merchant cash advance loans is that the borrower must use a third-party payment processor, such as PayPal, to collect a portion of monthly sales. It doesn't matter that some of the borrowed funds are backed by tangible assets; the loans are still classified as unsecured.

Criteria for an unsecured loan

Lenders want assurance that they will get paid back before agreeing to give you a loan. Unsecured loan applications may be asked for the following details to help lenders assess the applicant's level of risk:

Your Score

Credit reports are reviewed by potential lenders to see how well you handle debt. Lenders prefer applicants with a lengthy track record of timely payments, low credit card balances, and various account types. They will also look at your credit scores, which are based on the data in your credit reports. Borrowers who have credit scores of 700 or above are often offered the finest terms by financial institutions.

Cash flow

Knowing that you can afford to make loan installments reduces the risk to the lender. Lenders typically seek recent pay stubs or other evidence of regular and adequate income.

Debt-To-Income Ratio

A person's debt-to-income ratio is determined by taking their entire monthly debt payments and dividing them by their total monthly gross income. If you're making monthly payments of $500 on debt and have a gross monthly income of $2,000, your debt-to-income ratio is 25%.

This figure is used by loan providers as a proxy for your potential repayment capacity. That ratio ought to be as low as possible. Although the maximum allowable DTI varies from lender to lender, it seldom exceeds 43%.

Assets

Lenders of unsecured loans don't need collateral to approve a borrower, but they might want to see that you have some cash stashed away. When you have savings for unexpected expenses, you are less likely to fall behind on loan payments.

Important Considerations

Legal safeguards shield borrowers from unfair lending practices, even if a lender's decision to grant or deny an unsecured loan ultimately rests on the lender's assessment of the borrower's creditworthiness.

For instance, since the passage of the Equal Credit Opportunity Act in 1974, lenders are prohibited from considering a borrower's race, color, sex, religion, or any other factor unrelated to the borrower's ability to repay the loan when making a decision about the borrower's application for credit or the terms of the loan.

While prejudice has decreased, it still exists in the loan industry in the United States. The Consumer Financial Protection Bureau, responsible for overseeing and implementing the ECOA, released a Request for Information in July 2020 to get public feedback on how the law should be strengthened to better protect consumers from discrimination when seeking credit.

Related Articles