What Is an Unsecured Loan?
An unsecured loan is a type of loan that does not require the borrower to pledge any assets as collateral. Unlike secured loans, where the lender can seize your collateral in case of payment default, unsecured loans rely solely on your credit score, credit report, and financial stability.
Unsecured loans are a highly popular form of consumer debt. However, because these loans are not backed by collateral, they are riskier for lenders. As a result, lenders charge higher interest rates and have stricter credit requirements for borrowers. The higher your credit score, the better terms you can get for unsecured loans.
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How Unsecured Loans Work
Unsecured loans can be an ideal form of financing if you don't want to use collateral to back a loan or have cash to make a purchase. These loans are lines of credit or lump sum payments issued to you by banks, credit unions, and other financial institutions.
Without the financial backdrop of collateral, lenders rely on your income level, current debts, credit history, DTI, and both your FICO and VantageScore to create your financial profile. Based on this information, you will meet some lender’s preapproval process to qualify for credit products. Depending on the size of the unsecured loan, you might have to have a hard credit inquiry to assess your creditworthiness.
Once approved for an unsecured loan, you immediately get access to the line of credit or lump sum payment. Your monthly payments will begin once you use your credit card, POL, or personal loan.
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5 Types of Unsecured Loans
Here are five unsecured credit products you should know that are used every day by bank and credit union customers:
1. Personal Loans
Personal loans are standard unsecured loans used for various purposes, such as debt consolidation, home improvements, medical expenses, or major purchases. They are typically repaid in fixed monthly installments over a set term.
Personal loans offer flexibility and convenience, as they can be used for almost any purpose. They can also help you boost your credit score by demonstrating responsible repayment behavior. However, personal loans typically come with higher interest rates than secured ones.
The interest rates on personal loans can vary significantly depending on your credit score, loan amount, and repayment term. You should compare offers from different lenders to secure the best possible interest rate and loan terms.
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2. Personal Line of Credit
A personal line of credit (POL) is a revolving credit line that gives you access to a preapproved credit limit. You can withdraw funds from the line of credit as needed and repay the borrowed amount, plus interest, over time.
Personal lines of credit offer flexibility and convenience because you can access funds as needed and only pay interest on the amount you borrow. POLs can also help manage unexpected expenses or cover short-term financial needs. However, personal lines of credit can be risky if not used responsibly.
3. Unsecured Credit Cards
Unsecured credit cards are the most common type of unsecured loan. There are different types of credit cards that provide you with a line of credit that can be used to make purchases. Credit card balances are typically repaid in monthly installments, and interest is charged on the outstanding balance.
Unsecured credit cards offer convenience and flexibility for everyday purchases. They also help you build credit history and improve your credit scores by demonstrating responsible credit card use. However, if not used responsibly, credit cards can be a source of significant debt.
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4. Installment Loan
An installment loan is a type of loan that is repaid in fixed monthly installments over a set term. It can be used for various purposes, such as home improvements, medical expenses, or debt consolidation.
Installment loans offer a predictable repayment schedule, making budgeting and managing your finances easier. They can also help you improve your credit scores by demonstrating responsible repayment behavior. However, installment loans can be expensive if the interest rates are high.
Before taking out an installment loan, you should carefully consider the interest rates, loan terms, and repayment schedule. Comparing offers from different lenders can help you find the most affordable and suitable option.
5. Consolidation Loan
A consolidation loan is a type of loan used to combine multiple debts into a single, more manageable loan. This can be helpful if you are struggling to keep track of multiple loan payments and interest rates.
Consolidation loans can simplify debt management and reduce monthly payments. They can also lower the combined debt's overall interest rate. However, consolidation loans do not eliminate the underlying debt.
You must continue to make timely payments on the consolidation loan to avoid further damaging your credit scores. It is essential to carefully consider the terms and conditions of the consolidation loan and ensure that it will genuinely help to improve your financial situation.
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How to Get an Unsecured Loan
Getting approved for an unsecured loan can change your personal finances. Follow these seven steps to get approved for the loan you need:
1. Review Your Creditworthiness: Evaluate your credit history and credit score to determine your eligibility for an unsecured loan. You can boost your credit score by paying off statement balances, lowering your credit utilization, and making on-time payments.
2. Select Your Loan: Banks, credit unions, and other lenders offer a variety of unsecured loans to match your financing needs. For example, if you need a lump sum loan to renovate, you don't need a personal line of credit or a credit card. (Read more about cash back credit cards).
3. Find the Best Lender: Shopping for the best financing deal is critical to your search and evaluation process. Loans can vary by the approved principal amount, Annual Percentage Rate, term, fees, or other features. Compare and contrast offers from different lenders to find the most favorable terms possible.
4. Complete the Loan Application: Each lender will require you to submit a loan application. Your loan application will contain personal information like your name, address, income level, and other debts. During this information-gathering phase, lenders get data to calculate your debt-to-income ratio. (Read about how to get the promotion you deserve).
5. Undergo Credit Checks: Lenders will conduct credit checks to verify your identity and financial history. Depending on the lender, you may receive preapproval for a loan. Lenders sometimes conduct what is called a soft credit check for preapprovals. Alternatively, lenders will perform a hard credit inquiry to evaluate your creditworthiness.
6. Loan Approval: After reviewing your complete application, the lender will determine if you need their minimum borrowing profile. Once approved, you will receive an email or letter indicating that your application has been approved with instructions on how to access your funds. (Read our picks for the Best High-Yield Savings Accounts).
7. Receive Funds: Once your loan application is approved, your lender will disburse your funds. If you applied for an installment or personal loan, the funds will likely be directly deposited into your checking or savings account. You will have access to your lines of credit for POL and credit cards.
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Pros of Unsecured Loans
- Flexibility and Convenience: Unsecured loans are highly flexible and convenient. You can use products like credit cards to pay for everyday purchases quickly. One of the best features is that you don't have to pledge any assets as collateral. (Read more about How to Apply for a Cash Back Credit Card).
- Quick Access to Funds: Once you are approved for an unsecured loan, you can quickly access your line of credit, installment loan, or personal loan to begin using the funds immediately. Some credit card providers will even provide you with early access to your credit card number. (Read more about How to Get a Credit Card Cash Advance).
- Credit Building Opportunity: Unsecured loans can be a great way to build up your credit history. For first-time credit card users or those trying to re-establish their credit scores, these lines of credit or loans tend to cap their credit limits. Making on-time payments on unsecured loans can help improve your credit score. (Read more about the 5 Steps to Lower Your Credit Utilization).
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Cons of Unsecured Loans
- Higher Interest Rates: Unsecured loans typically have higher interest rates than secured loans due to the lender's increased risk. If a lender makes a mistake, it has no recourse besides reporting this information to the Credit Bureaus.
- Stricter Credit Requirements: You need to have your finances in order to get an unsecured loan. Lenders require a higher credit score, more extended credit history, and low DTI. Unsecured loans can be challenging to get for borrowers with poor or limited credit histories. (Read more about When to Talk to a Financial Advisor).
- Potential for Financial Hardship: Defaulting on an unsecured loan can significantly impact your credit score and make it difficult to obtain future credit. In fact, missed payments can show up on your credit report for seven years.[1]
Smart Summary
Unsecured loans do not require you to pledge assets as collateral. These loans provide flexible and convenient ways to access credit when you don't have the cash on hand. However, they also come with higher interest rates and strict credit requirements. You should carefully consider the terms and conditions of any unsecured loan and only borrow what you can afford to repay. (Read more about the different types of monthly budgets).
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(1) Equifax. Can You Remove Late Payments from Your Credit Report? Last Accessed February 4, 2025.
