When someone purchases a home or a motor vehicle they generally take a loan for a portion of the purchase price. In this instance, the lender has collateral in the form of the asset; these are considered secured loans. An unsecured loan means there is no underlying collateral for the lender to seize in the event the borrower fails to make payment.
Inherent risks of unsecured loans
When a lender places a lien on a home or an automobile, they can get the property back if the borrower fails to make payment. However, the only option available to lenders who carry unsecured loans is to force collection activities. Frequently, if a borrower has a great deal of unsecured debt, credit cards for example, that they are unable to pay, they file for bankruptcy protection.
Credit scores and unsecured loans
Generally speaking, if a borrower is seeking an unsecured loan, they must have an excellent credit score. This is particularly true if they are borrowing money for debt consolidation, medical expenses or even to facilitate an adoption. For most borrowers, the higher their credit score, the less they will pay in interest, as lenders see them as a less risky borrower.
Interest rates on unsecured loans
Lenders are taking risks when they offer an unsecured loan. In fact, anyone who has a credit card understands they are going to pay high interest rates. While unsecured loan rates are not as high as credit cards, they are still significantly higher than a secured loan. Sun Trust, a U.S. based lender, offers the following estimated rates on various loans as of June 2016:
- Car loans – 1.99 to 3.04
- Home improvement – 3.99
- RV/boat loans – 2.99
These are all secured loans, meaning the lender has collateral. However, take a look at the rates offered on loans that are not secured by real property:
- Debt consolidation – 4.99
- Medical expenses – 5.99
- Other unsecured loans – 5.99
Borrowers should anticipate paying as much as one to two percent higher for a loan that has no underlying collateral.
When does an unsecured loan make sense?
For borrowers considering an unsecured loan it is important to make sure there are sufficient reasons for taking the loan. In most cases, the interest on these loans is not tax deductible. Additionally, failure to make payments in a timely manner often means the interest rate will increase and the borrower may also be facing steep late payment charges. Lenders often take aggressive steps to collect past due amounts, particularly when there is no underlying asset to protect their interests.
Unsecured loans make sense for borrowers who have credit cards with high interest rates they wish to consolidate into one loan, with a lower interest rate and one monthly payment. In these cases, an unsecured loan can help the borrower increase their credit score, lower their monthly expenses and provide a fixed-rate interest payment versus the variable rates on many credit cards.
Borrowers who are financially secure but have high credit card debt or medical debt may benefit from an unsecured loan. As with any loan, borrowers should carefully review the lending documents and make sure they have a full understanding of the loan terms before signing the final papers.