What are the Pros and Cons of Unsecured Loans?

K. Kinsella

Unsecured loans are loan agreements that are not secured by collateral. Lenders offer a variety of different unsecured loan options to both consumer and business borrowers. Signature loans, revolving credit lines, and credit cards are among the most commonly used forms of unsecured debt. The absence of collateral means that people with no equity in their homes or vehicles can still borrow, although the borrowing costs are generally higher and loan terms more restrictive than on secured loans.

Credit cards are one of the most common types of unsecured loans.
Credit cards are one of the most common types of unsecured loans.

Lenders typically only write home loans with terms lasting between 10 and 30 years, which make mortgages an unattractive option for people needing only short-term funds. Many lenders offer unsecured loans with term times of 24 months or less, which means borrowers can quickly payoff their debt. Shorter term periods mean higher payments, and for people on a limited income unsecured loans can be very costly. Unsecured loan payments can be stretched out over longer periods of time, but lenders normally cap loan terms at five or ten years.

Collateral on a loan serves provides the lender with some recourse if a borrower defaults on a loan, and it also functions as evidence of the borrower's good faith because borrowers typically do not offer up collateral for debts that they intend to default on. Lenders have limited recourse against borrowers who default on unsecured loans and to mitigate the risk these loans pose, lenders charge much higher rates of interest. Additionally, most unsecured loans have variable interest rates which means minimal payments in low rate environments, but payments can rapidly increase once rates start to rise.

The loan process normally involves the lender checking the credit report of the borrower. Credit reports give the lender an insight into the borrower's character and credit handling skills. People who frequently default on debt payments are a high credit risk, and people who never make late payments pose a very low risk level. Borrowers with good credit scores can take out unsecured loans with relatively low interest rates but in the absence of collateral, lenders do not typically write unsecured loans for people with poor credit.

People who fall on hard times sometimes end up defaulting on their debts. Since unsecured loans involve no collateral, a borrower does not risk losing his home or other property if he defaults on an unsecured loan, although laws in some nations allow creditors to place a lien on a home until the debt is settled. Even if a creditor cannot place a lien on property, charged off debts negatively impact credit scores, and could make it difficult for a borrower to obtain credit in the future.

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