A debt instrument with no collateral attached to it
An unsecured note is a debt instrument with no collateral attached to it. In this case, the entity or person issuing the debt does not guarantee the investor/ lender to pay him back his money. As a result, unsecured notes generally carry high-interest rates.
Unsecured loans include student loans, personal loans, and revolving credit such as credit cards. A borrower is usually expected to have an excellent credit score and a steady source of income to qualify for attractive loan terms.
Those types of loans are also called signature loans since a signature is all that's needed if the borrower meets the lender's borrowing requirements. However, due to the high risk involved when lending such a note, it carries higher interest rates and requires excellent credit history.
If a borrower stops making payments due to unforeseen circumstances and defaults on the unsecured loan, there's no collateral for the lender to take to recover the outstanding debt. For instance, let's say a borrower becomes unemployed as a result of an economic crash.
In that situation, the latter is not able to repay their unsecured note and unsecured credit card debt. When the loan accounts default, the borrower's credit will be adversely affected, and in this case, lenders might have no alternative but to bear the financial loss.
Types of unsecured loans
Personal loans - Usually used when dealing with an emergency or meeting pressing financial goals. Some lenders also label them as home improvement loans, wedding loans, or debt consolidation loans
Student loans - Designed to offset the cost of higher education
Credit cards - Used to make everyday purchases or cover unexpected expenses.
Criteria that are Assessed Before Issuing an Unsecured Loan
When issuing the loan, lenders will want to assure that the borrower can repay the loan to limit their risk. Lenders assess that risk by going through a few factors, so they may ask about the following information when an individual is applying for an unsecured loan.
Credit History - Lenders check the credit reports of the last 12 months to see how a potential borrower has managed loans and credit cards in the past. They look for a history of responsible card use, low credit card balances, and a mix of account types.
The credit score is also calculated based on the information in the credit reports. Consumers with credit scores around 700 or more usually qualify for the best interest rates.
Income - Knowledge that you have the means to meet your financial obligations, including loan payments, significantly lowers the lender's risk. Therefore, the lender usually asks for proof of stable, sufficient income, such as a current pay stub.
Debt-to-income ratio - Lenders will use the figure derived from this ratio to measure a borrower's ability to repay a loan. The lower the ratio, the better it is. In most cases, different lenders will have different requirements for the DTI.
The monthly debt payments are added and divided by the monthly income to calculate the debt-to-income ratio. For example, if the amount of debt payments sums up to $500 while gross income adds up to $2,000, then the resulting DTI is $500/ $2,000 or 25%.
Assets - Even if unsecured loans don't require collateral, the lender will want to check if a potential borrower has enough savings. Someone showing proof that he possesses enough funds will indicate they are less likely to miss loan payments.
Who should be granted such a loan?
Whether an unsecured loan is a right option depends on the borrower's financial situation and the fund's purpose. Those in need of money but aren't comfortable pledging collateral to secure a loan can consider one and be eligible for one in the following instances:
They have good credit - A high credit score opens the scope for more favorable unsecured loan terms and interest rates.
They have a reliable source of income - Even if the collateral isn't necessary for an unsecured loan, a steady income is required to repay the debt and any non-payment of the loan.
Planning for a large purchase - Taking on the burden of debt certainly adds pressure on one's finances, but if funds are essential for funding a significant expense, then lending the necessary fund to a borrower can help.
Unsecured Vs. Secured Loan
|Unsecured Loan||Secured Loan|
|Not tied to any specific asset||Tied to an asset like property or motor vehicle|
|An individual is entitled to an unsecured loan even if he does not own property to back up as collateral.||You can borrow more significant amounts than an unsecured loan since lenders are confident they will get their money back, either from loan repayments or the sale of the collateral.|
|The application process for an unsecured loan often goes much quicker than getting a secured loan.||They typically come with a lower interest rate than unsecured loans as it involves lower financial risk for the lender.|
|They tend to be harder to obtain if the borrower does not have a positive credit history or lacks a regular stream of income. This implies that the borrower might need to look for a co-signer with good credit history and a solid income to sign the loan documents.||The amount borrowed is limited to only purchasing a specific asset such as a home or a car.|
When issued to an individual or company (borrower), it is accompanied by a specific item of personal property, also known as collateral. This item can be a house, a boat, a car, or even stocks and bonds.
For instance, when a car is used to secure a loan, the lender maintains ownership rights in the assets until loan repayment. This means that failure to repay the loan or meet the terms of the loan agreement will lead the lender to seize and sell the car to repay the loan.
Moreover, with a secured loan, the lender also places a lien on the collateral. This serves as a purpose in an instance whereby if the borrower sells the car, the lender is entitled to receive the money to pay off the remaining loan balance before receiving any money from the sale.
The most common type of secured loan is a mortgage backed by the purchased asset. If the borrower ceases to make mortgage payments, his lender could foreclose on the personal property and sell it to pay off the mortgage.
The Application Process
Applying for an unsecured loan is simple as compared to a secured loan. Moreover, it can be completed online from the comfort of your home. Nevertheless, there are still a few important steps to ensure you get the best deal from the lender. These are listed below.
Check your Credit Score - Prospective borrowers are expected to meet the minimum requirement of a score between at least 610 and 640 to qualify for a personal loan.
They should use a free online service to see whether their credit score meets the eligibility criteria, as this will help them anticipate the likelihood of their application being approved or not. It also allows applicants to improve their credit scores before submitting their applications.
Evaluate Your Budget - After reviewing your credit score, the next step will be to evaluate your current income and expenses. Even though there won't be any collateral in pay in the case of an unsecured loan, late payments still affect your credit score.
The loan applicant must also go through his debt-to-income ratio (DTI), as borrowers often insist that a DTI of at least 36% or less is required to qualify for a new unsecured loan.
Search for lenders and Prequalify - Once your finances are secured, start shopping for lenders that offer competitive annual percentage rates (APRs). It allows borrowers to see what type of APRs and loan terms they are likely to qualify for prior to submitting their application.
Gather Documentation - After finding a promising lender and ready to get started, it's time to research its application process. Collecting any documentation, such as tax returns, is also advisable to help speed up the application approval and funding process.
Submit a Formal Application - The last step will be to finalize the loan application and submit it either online or in person. It is nowadays possible to benefit from the online application process as well as quick approval times and same/ next day funding.
It is nevertheless vital to discuss the loan details with someone from the lending institution, such as a credit analyst since an application process might vary by lender.
If a borrower has constantly defaulted on his loan repayments, it turns into a bad loan that can eventually be written off.
Yes. If you have an unsecured loan and a lender already has a court order to demand payment, they launch an application to the court to get a charging order over your asset.
Repayment time can range from two to five years, but some can last till seven years.
Failure to make payment on an unsecured loan doesn't allow the creditor to take any of your property without first starting a court appeal and getting a court judgment.
Creditors of unsecured loans get paid on a pro-rata basis. They all receive the same percentage of the balance owed from the borrower.
Yes. Many banks provide the option of online applications for unsecured loans.
An unsecured claim is a payment request initiated by the lender to the bankruptcy court when the latter doesn't have the right to sell the property to satisfy the underlying debt.