An unsecured loan is money lent from one party to another without any collateral to secure its repayment. In most cases, these types of loans are considered somewhat high-risk, since the lender does not usually have any way of forcing the borrower to comply with the terms or make payments on time short of legal action. For this reason, most unsecured loans carry relatively high interest rates and are often only available to those with strong credit scores.
Reasons for Pursing an Unsecured Loan
Unsecured loans are used primarily for small, short-term expenses, such as medical crises or wedding or funeral costs. They are usually intended to be paid back within about a year, though the terms can vary depending on the amount at issue and the relationship between the lender and the borrower. When borrowers do not have a lot of valuable property, pursuing an unsecured loan may be one of their only ways of getting access to needed funds.
Simplicity is another reason to seek an unsecured loan. When only small amounts of money are at issue, it is not usually worth the hassle of transferring property titles and establishing a collateral relationship. A simple contract can often be the best way to proceed, even if there are other trade-offs.
Bank customers often apply for unsecured loans as a means of getting fast access to cash. Unlike home loans or car loans, which are normally secured by the house or automobile itself, unsecured loans are simply given on the borrower’s word to repay. There are always contracts to sign and papers to process, but there is nothing the bank can seize if the borrower fails to repay the money lent. This type of unsecured loan may also be called a “signature loan.”
Banks will not usually extend unsecured loans to just anyone. A customer must usually have a stable income, as well as a history of on-time payments and trustworthiness, in order to be considered.
Unsecured Personal Loans
Most of the loans that happen between family and friends are unsecured. These types of loans are often very informal, and may not be documented in writing. Parties usually come to an agreement about when and how the money will be repaid, but this is often unenforceable.
Credit Card Transactions
Purchases made with credit cards are usually structured as unsecured loans. Credit card companies extend a certain line of credit, secured only by the customer’s agreement to pay purchases back. Failure to make payments usually incurs fees and high interest rates, but not property seizure. When property is seized, it is as the result of a court order — usually issued to remedy chronic repayment failure — not because the property is collateral.
High interest rates are one of the characteristic features of almost all unsecured loans. By charging higher-than-normal rates, lenders are able to protect themselves against the risk of default. Most of the time, banks offer more competitive interest rates than credit card companies, but not always. Borrowers are usually wise to carefully investigate all options and terms before committing to any specific loan.
At least in the United States, individuals who hold secured loans — such as home loans, where the house serves as collateral — can often deduct any interest charged from their income tax returns. This almost never applies to interest in an unsecured arrangement.