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Unsecured Loans: What They Are And How They Work

Sarah Sharkey6-minute read
February 10, 2022

An unsecured loan is a general loan that you can apply for without putting up any collateral. Generally, you’ll need a strong credit score in order to take out an unsecured loan with competitive interest rates.

You can take advantage of unsecured loans to fund a variety of financial needs such as consolidating debt or committing to a large purchase. Depending on the lender, you may be able to successfully obtain an unsecured loan that can be used for any number of reasons. However, some lenders will put restrictions on how you are allowed to use the money.

If you have questions about unsecured loans, then you’re in the right place. We will take a closer look at what exactly an unsecured loan is below.

What Is An Unsecured Loan?

First, let’s dive into an unsecured loan definition.

An unsecured loan is provided to the borrower by the lender without any collateral. Instead of basing the loan terms on the collateral that you have available, the lender decides on the loan terms largely based on your creditworthiness.

Since there’s no collateral, these kinds of loans are generally considered more risky for the lender. With that, you’ll need to have a relatively high credit score in order to obtain attractive loan terms.

In most cases, you’ll be able to use the funds of an unsecured loan to take care of any financial needs. A few of the most common uses of an unsecured personal loan include funding weddings, consolidating other debts, home renovations, and paying for trade schooling. Other types of unsecured loans include student loans and credit cards.

Although some lenders place restrictions on how you can spend the money of an unsecured loan, you can likely find a lender that is willing to support your needs.

Unsecured Vs. Secured Loans: What’s The Difference?

The major difference between a secured loan and an unsecured loan is the need for collateral. With a secured loan, you will be expected to provide a valuable asset as collateral to secure the terms of the loan. If you default on the secured loan, you would forfeit the asset to your lender. With an unsecured loan, the lender is only able to set the loan terms based on your creditworthiness. If you default on the loan, the lender is unable to recoup their losses based on your assets.

A few examples of a secured loan include an auto loan, mortgage, and secured credit cards. In each case, the borrower has collateral on the line to mitigate the lender’s losses if they are unable to keep up with the payments.

In the event that you defaulted on your secured loan, the lender would be able to use the collateral that you’ve put up to recover their losses. If you defaulted on an unsecured loan, the lender would have a more difficult time recouping their losses.

Since a secured loan is less risky than an unsecured loan, you can usually expect higher borrowing limits and better loan terms for secured loans. For unsecured loans, borrowers typically have to accept higher interest rates and a more rigorous application process.

How Do Unsecured Loans Work?

Unsecured loans do not require you to pledge anything as collateral. Instead of evaluating your loan application based on your collateral, the lender will take a close look at your credit history.

In most cases, you can expect a fairly detailed application for unsecured loans. The lender will want to examine your credit, your income, and any current monthly payments that you have on your plate. Based on your current financial picture, the lender will determine whether or not they are able to offer you an unsecured loan.

If you are approved for the unsecured loan, then the lender will provide you with the offer details. You should clarify that the principal, or amount borrowed, is what you are looking for.

Take a close look at the interest rate and annual percentage rate attached to your unsecured loan. You’ll want to ensure that you get a competitive rate, so you may need to obtain quotes from multiple lenders. Finally, consider the monthly payment in light of your budget. Can you comfortably afford to make this payment each month?

It’s important to note that an unsecured loan is not completely without risk for the borrower. Although you will not lose any of your assets as a direct result of defaulting on an unsecured loan, it could lead to a big hit to your credit score.

When your credit score drops, you’ll find it more difficult to obtain loans of all kinds. Even if you are able to get approved for another loan with a lower credit score, you might find yourself paying higher interest rates on that debt which could cost you thousands over the course of the loan. With that, make sure that you are able to repay this loan on time before you submit an application.

Getting A Personal Loan Has Never Been Easier.

The Rocket LoansSM application process makes borrowing simple.

Types Of Unsecured Loans

Now that you have a better understanding of how a personal loan works, let’s dive into the different types.

  • Unsecured personal loan. A personal loan can provide borrowers with the funds to take care of a variety of financial issues. Most lenders, such as Rocket Loans®, will allow you to borrow a wide range of loan amounts to fund anything from debt consolidation to a wedding. A debt consolidation loan can roll different debt payments into one loan with one payment.
  • Unsecured credit cards. Unsecured credit cards give you access to a line of credit that can be used for any purpose with the swipe of your card.
  • Personal credit line. A personal credit line is a type of revolving debt that typically has a variable interest rate attached.
  • Signature loan. A signature loan will give you access to an unsecured loan with just your signature.
  • Education loan. Student loans are a type of unsecured loan. Education loans have the specific purpose of funding your student expenses. With that, they come with more restrictions than other types of unsecured loans.
  • Peer-to-peer. Peer-to-peer lending can come in a variety of forms. Whether you use an online platform to find an individual who is willing to lend you money or you seek out the help of family and friends, you’ll have the option of finding an unsecured loan.

Is An Unsecured Loan Right For You?

If you are interested in applying for an unsecured loan, then it’s important to check your credit score first. After you do this, you can decide if you’re ready to apply for an unsecured loan or if you need to work on improving your credit score first.

It’s critically important to improve your credit score before applying for an unsecured loan. Lenders will determine the success of your application and the terms of your loan based on your credit history. If they don’t like what they see, then you might find yourself with a denied application. Or you may be offered extremely high interest rates that could make your loan unaffordable.

Although it’s possible to obtain an unsecured personal loan with bad credit, it can be more difficult. If you have a bad credit score, then you may need to seek out a co-signer to boost your application. Many credit unions and banks will require one if you have a low credit score.

If you plan to secure quotes from multiple lenders for your unsecured loan, then make sure to submit your applications within a few weeks of each other. Otherwise, multiple loan application attempts can drag your credit score down. Although a hard inquiry will hurt your credit score, stretching out multiple hard inquires over the course of months will hurt it more.

A Final Word On Unsecured Loans

Unsecured loans can be useful if you have a high credit score and a big expense coming up. With your high credit score, you’ll have access to lower interest rates to make the unsecured loan more affordable.

However, if you have a low credit score, an unsecured loan may not be as useful. With a higher interest rate, it may be more difficult to stay on top of your monthly payments. If you miss even one payment, your credit score can be even further damaged. If you have bad credit, then you may want to stick to secured loans for now.

You can start working to improve your credit score today with the free resources offered by Rocket HomesSM. You’ll learn more about the components of your credit score and how to improve it over time. Take advantage of the free credit monitoring services today.

Getting A Personal Loan Has Never Been Easier.

The Rocket LoansSM application process makes borrowing simple.

Sarah Sharkey

Sarah Sharkey is a personal finance writer that enjoys helping readers learn more about their finances. She has an MS in Business Management from the University of Florida. You can connect with her on LinkedIn or Instagram @adventurousadulting.