An unsecured loan is a type of financing program that is made without the requirement or consideration of any additional collateral or lien placed on the borrower’s assets. Sometimes referred to as personal loans (in the consumer loan market), unsecured loans present greater risks for the lender, while minimizing the borrower’s potential exposure.
Common examples of unsecured loans include the following lending programs:
- Student loans
- Signature loans
- Payday loans
- Cash advance loans
- Credit card cash advances
With unsecured loans, the borrower will not have to pledge cash, a physical object, legal title or a lien on a property’s title to secure financing.
Some people, however, would argue that even the above unsecured loan borrowers do offer an intangible collateral for these types of loans: their credit. If they fail to pay as scheduled or default on these unsecured loans, their credit ratings – which do have value – could be damaged. From this perspective, the above loan programs could not be completely considered unsecured loans.
Within the wider consumer loan industry, however, the phrase unsecured loan does not view one’s credit as collateral for a loan.
Unsecured vs. secured loans
One way to understand unsecured loans is to compare them with financing that does require collateral or security. As a condition of approval or funding, a secured loan requires the borrower to provide or pledge an asset to the lender as collateral for the loan.
That asset becomes security for the loan. Today, secured loans have become an integral part of America’s economy and include the following examples:
- Car loans. A common type of secured loan is an automobile loan. Most automobile lenders will issue a loan and hold the title to the car being financed. If the borrower fails to make payments as agreed, the lender can use the title to repossess the vehicle from the borrower.
- Mortgage loans. The biggest debt many Americans will ever carry is the financing they use to buy or refinance their home. A mortgage loan is secured by the title to the home or other real property, which is “mortgaged” to obtain the loan funds.
- Business loans. Many companies put up their business assets, including unpaid receivables, to secure commercial business loans.
- Pawn loans. Perhaps the oldest form of secured financing is the pawn shop loan. Whether pawning jewelry, electronics or automobile, the pawn shop will keep actual possession of the security item until the loan is fully paid.
Another form of security may actually arise with some nominally “unsecured” loans: wage garnishments. Some loan agreements give the lender or creditor the right to garnish the borrower’s wages in order to satisfy the loan balance.
Similarly, some states consider personal loans that require an ACH or direct deposit setup before issuing a loan to be a form of collateral. Through the ACH or direct deposit setup, the borrower’s checking account effectively becomes security for the loan.
When such conditions are present in a loan agreement, that loan probably would not be considered a true unsecured loan.
Risk and security
Because unsecured loans do not require any collateral, they are less risky for the borrower than a similar loan that does require some sort of security. The flip side of this equation, however, is that unsecured loans can increase the lender’s risk exposure.
When payments on an unsecured loan are not made, the creditor can’t take away personal property like cars, homes, or other belongings to recover their lost loan funds. In this situation, the lender can report the borrower’s negative payment history or default status to credit bureaus, negatively impacting the borrower’s credit score. The lender can also begin loan collection attempts, but unless the loan agreement garnishes the borrower’s wages or assets, many lenders may have a difficult time collecting.
Risk is a guiding factor for most institutional lenders. They know that every loan or credit line issued to a borrower involves some degree of credit. Lenders rely on their application and underwriting process to determine whether a prospective borrower presents an acceptable credit risk.
If an applicant for an unsecured loan poses too high of a credit risk, some lenders or creditors will require collateral to mitigate or lower the lender’s risk exposure. For example, a consumer’s application for a standard credit card may be declined because of less-than-perfect credit, but the creditor may offer a secured credit card option instead.
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