An unsecured personal loan, also referred to as a signature loan, occurs when an individual borrows money without backing the loan with collateral. The money loaned is intended for personal use, rather than business expenses. It is granted to the borrower mainly depending on his or her integrity and ability to pay the loan back over the agreed term. The counterpart to an unsecured personal loan is a secured loan, or a loan that is backed by some kind of asset.
In a secured loan, the person who borrows the money will do so while pledging a certain piece of property, the asset, to the lender as collateral. If the borrower defaults on the loan and breaks the loan agreement, the lender will then be allowed to claim this property. For example, if a vehicle is used as collateral for a secured personal auto loan, the lender will typically repossess that vehicle if the borrower ceases to follow the terms of the lending agreement. If a home is used as collateral, it may be foreclosed upon by banks after a person can no longer make their house payments every month. In the case of an unsecured loan, the bank has no such avenue if the borrower cannot pay.
Generally, an unsecured personal loan is a greater risk to a lender since there are no assets to procure should the borrower default. This is where the borrower's credit rating applies; the lender can use the rating to gauge the risk that someone may default on a loan. Those with stellar credit records and a high credit score will most likely be able to take out an unsecured personal loan from a financial institution.
Another factor banks consider is the annual percentage rate (APR) of the loan, which is the value of the interest that will be paid by the borrower to the lender. Someone taking out an unsecured personal loan who also has bad credit will most typically end up paying much more in interest. Conversely, a good credit score can lead to lower APRs for borrowers, increasing the importance of maintaining a good credit history.
Banks, credit unions, and companies in the business of lending money are not the only sources of unsecured personal loans. One can also borrow money from a friend, relative, or acquaintance. When this is the case, the relationship between the lender and the borrower, as well as the reputation of the borrower, can be at stake. When making an agreement for an unsecured loan from a friend or family member, the borrower must carefully consider the consequences should a problem arise in repaying the loan.