Unsecured Loans: Borrowing Without Collateral

What Is an Unsecured Loan?

An unsecured loan is a loan that doesn’t require collateral. Lenders approve unsecured loans based on a borrower’s creditworthiness.

Examples of unsecured loans include personal loans, student loans, and credit cards.

Key Takeaways

• An unsecured loan is supported only by the borrower’s creditworthiness, rather than collateral.
• Unsecured loans are riskier for lenders, so they require higher credit scores for approval.
• Credit cards, student loans, and personal loans are examples of unsecured loans.
• If a borrower defaults on an unsecured loan, the lender may use a collection agency or take legal action.
• Lenders can decide whether to approve an unsecured loan based on a borrower’s creditworthiness, but laws protect borrowers from discriminatory practices.

How an Unsecured Loan Works

Unsecured loans, also known as personal loans, do not require collateral. Approval and receipt of these loans depend on a borrower’s credit score. High credit scores are typically necessary to be approved for unsecured loans.

This differs from secured loans, where borrowers pledge assets as collateral. For example, mortgages and car loans are secured loans.

Since unsecured loans require higher credit scores, lenders may allow applicants with insufficient credit to provide a co-signer. This person takes on the legal obligation to repay the debt if the borrower defaults.

Because they are not backed by collateral, unsecured loans are riskier for lenders. Consequently, they come with higher interest rates.

If a borrower defaults on a secured loan, the lender can repossess the collateral. On the other hand, if a borrower defaults on an unsecured loan, the lender cannot claim any property. However, the lender can take other actions, such as using a collection agency or taking legal action. If the court rules in the lender’s favor, the borrower’s wages may be garnished.

Defaults can have consequences, such as lower credit scores.

Types of Unsecured Loans

Unsecured loans include personal loans, student loans, and most credit cards. They can be revolving or term loans.

A revolving loan has a credit limit that can be spent, repaid, and spent again. Examples of revolving unsecured loans include credit cards and personal lines of credit.

A term loan is repaid in equal installments until the loan is paid off at the end of its term. While these loans are often associated with secured loans, there are also unsecured term loans. For instance, a consolidation loan to pay off credit card debt or a signature loan from a bank falls under unsecured term loans.

In recent years, the unsecured loan market has grown with the rise of peer-to-peer (P2P) lending facilitated by fintech firms.

$1.295 Trillion

The amount of U.S. consumer revolving debt in Oct. 2023, according to the Federal Reserve.

If you’re considering an unsecured loan for personal expenses, a personal loan calculator can help you determine the monthly payment and total interest for the desired amount.

Unsecured Loan vs. Payday Loan

Alternative lenders, such as payday lenders or companies offering merchant cash advances, do not provide secured loans in the traditional sense. However, they take measures to secure repayment.

Payday lenders require borrowers to give them a postdated check or agree to an automatic withdrawal from their checking accounts. Many online merchant cash advance lenders also require a percentage of online sales through a payment-processing service like PayPal. Although partially secured, these loans are considered unsecured.

Payday loans can be considered predatory due to their high interest rates and hidden terms, leading some states to ban them.

Special Considerations

Laws protect borrowers from discriminatory lending practices. The Equal Credit Opportunity Act (ECOA) has established clear standards to prevent lenders from using non-creditworthiness factors when evaluating loan applications or establishing loan terms.

While lending practices have become more equitable, discrimination still exists. In July 2020, the CFPB issued a Request for Information to improve the ECOA’s effectiveness in ensuring nondiscriminatory access to credit.

What Is Considered Collateral?

Collateral includes real estate, automobiles, jewelry, and other valuable items.

Is a Co-Signed Loan Considered Secured?

Having a co-signer helps with loan approval, but it does not make the loan secured. In case of default, the co-signer is responsible for repayment.

Can Bankruptcy Eliminate all Unsecured Loans?

Declaring bankruptcy usually eliminates unsecured loans, except for student loans. To have student loans forgiven, the debtor must prove an undue hardship in an adversary proceeding. Streamlined paperwork is making it easier to discharge even federal student loans used for living expenses.

The Bottom Line

Unsecured loans are common but bear significant risk. Assess your financial health and ability to repay the loan before borrowing. Defaulting can result in wage garnishment and tax return seizure, creating a challenging path to solvency.