Unsecured personal loans provide people with the money they need, even if they don’t have collateral to back their loan.
Collateral is something of value (like your car or home) that borrowers use to guarantee that their loan will be repaid. If the loan is not repaid, lenders can take the collateral to make up for their loss. Unlike mortgage loans or home equity lines of credit (which use your home as collateral), unsecured loans aren’t tied to your property, which is beneficial if you don’t have property to use as collateral.
Since unsecured loans are not backed by collateral, there’s a bigger chance that the lender may not be repaid. Lenders often charge higher interest rates to make up for these risks.
Rates for mortgage loans or home equity loans (which use your home as collateral) are usually much lower than the interest rates of unsecured loans, which can easily be more than 10%. (Even the lowest rates are around 8%.)
The higher the interest rates are, the more costly the loan. In addition, interest rates for unsecured loans are not considered tax deductible, whereas the interest paid on mortgage loans or home equity loans usually are.
While interest rates for unsecured personal loans are higher than secured loans (such as mortgages or car loans), they may be lower than most credit card rates. Depending on the terms, you may also be able to choose an unsecured loan with a fixed interest rate; credit card rates are often variable rates (meaning the rates can change).
Lenders offer more than one loan term option for unsecured personal loans.
One option for an unsecured personal loan is a fixed term, in which you are loaned a fixed amount of money and make scheduled payments to ensure the debt is repaid at the end of the stated term. This option is best for individuals that may not have the self-discipline to repay debt without a structured plan.
Fixed terms also provide fixed interest rates, which means interest rates will not increase or decrease throughout the life of the loan, making it easier to plan for payments.
The second option is the revolving line of credit. In this scenario, you are allowed to borrow a specified amount. When you pay down your balance, making the credit available to borrow again, you can borrow more money. The availability of the credit depends on whether you’ve paid down the balance or not. Credit cards are an example of a revolving line of credit.
Revolving lines of credit are usually accompanied by variable interest rates, or rates that can increase or decrease depending on the market. If interest rates increase, your payments can too, sometimes making repayment more difficult if interest rates jump unexpectedly.
Unsecured personal loans are also available to people with bad credit. Usually, bad credit makes it difficult to obtain loans because borrowers typically have a history of repaying debt late. Lenders are now offering more and more unsecured personal loans to people with bad credit, recognizing that often times, we don’t understand how credit works until after we have tarnished it.
Though unsecured personal loans for bad credit borrowers still do not require collateral, the interest rates can be even higher than the rates of a typical unsecured personal loan. This is because the risk of not being repaid increase when lending to borrowers of bad credit. Higher interest rates result in higher loan costs overall.
Since unsecured loans with high interest rates are so expensive, it is best not to use them for frivolous expenses or unnecessary costs. Instead, consider building a savings account for big purchases or planned expenses. Meanwhile, improve your credit to put yourself in a better financial position for the future.
Don’t confuse payday loans with unsecured personal loans.Even though neither requires collateral, there are some big differences.
Unsecured personal loans can provide as much as $50,000 without collateral, but payday loans are designated for much smaller amounts - only up to $1,000. Payday loans are only recommended for emergencies and typically average $300.
Annual Percentage Rates, or APR, is the interest charged for a loan over a year’s time. Lenders and borrowers alike use APR to determine the overall cost of a loan when comparing loan options. Like unsecured personal loans, payday loans have much higher interest rates since they do not require collateral, and rates increase when lending to people with bad credit.
The major difference is that payday loans typically have much shorter repayment terms, so when you convert the flat rate fee to an APR, the annual interest rate is much higher than that of a typical unsecured personal loan. In fact, the average APR of a payday loan is 365%.
In addition, payday loans charge a fee if you extend the due date of this short-term loan. Though the fee seems reasonable, about $15 for a $100 payday loan, they quickly add up and become difficult to manage.
Payday loans and unsecured personal loans can be an expensive way to pay for something, especially if you don’t really need it or if you don’t need it right away. The interest rates charged make your purchase more expensive, turning a $100 item into a $115 item.
Take your time deciding if it is worth using a payday loan or unsecured personal loan and paying out more in interest rate charges. Do your homework, compare your options, and decide if the loan (or purchase) can wait. Become familiar with your finances and your credit so that you know what you’re getting yourself into. Then when you're ready you can apply for a loan here.