Unsecured loans are loans that have no collateral, like a home or a car or stock, backing up the loan and available to the lender if the loan goes bad. These loans are issued solely on the promise of the borrower to pay it back according to agreed upon terms. A document, usually a loan contract is signed and the money is issued. These loans are also known as signature loans.
Usually unsecured loans are for one time expenses like a medical bill or help in meeting a down payment on a home or expensive auto or perhaps taking advantage of a lower interest rate to pay off other, high interest rate debts. They can be a useful financial tool for the borrower but they can also be fraught with danger. Here are a few of the pros and cons of unsecured loans that you should be aware of.
Perhaps the simplest of unsecured loans is the old IOU where the borrower gets funds from a friend or family member. These loans should be entered into, particularly by the lender, very carefully. There’s usually a reason why the borrower is going to a family member rather than a financial institution. If the loan goes bad, it’s not just bad debt it could be bad blood and a family relationship ruined.
2. Credit Cards
The most popular form of unsecured loans is by far and away the billions in credit card debt that consumers rack up each year. You may not think of a credit card transaction as a loan but it is. You purchase an item with what is essentially a loan or credit and you sign a form promising to pay it back. While the credit card company is paying the merchant for your purchase, you are obligated to pay the card company according to the terms and conditions you agreed to when you got the card. In the past, if your credit rating slipped, the card company could arbitrarily increase the interest rate you pay some going as high as 30%. Thanks to a recently passed law, that practice is now banned.
3. Banks and Credit Unions
Some banks still offer signature loans but they are more likely to offer a personal line of credit. How much you qualify for and at what interest rate depends on your credit worthiness. Credit unions typically have lower rates for unsecured loans and if you have good credit, getting the loan should be no problem.
4. Astronomical interest rates
Lending institutions argue that because no collateral is offered to secure a loan there is a greater risk and that justifies a greater interest rate. If you have bad credit and you go for one of the short term loans you could be paying as much as 400% APR. Consumers don’t really see it that way because those loans are usually so small (less than $1000) all they are really concerned with is what the payment is. For example a $250 loan for 2 weeks will require a total payback of $234. $34 doesn’t sound like much to a consumer who needs cash now but it is a huge profit for the lender.
5. Unsecured loans can be discharged in bankruptcy
If you have to file bankruptcy, chances are your unpaid unsecured loans will be totally discharged as they have the least rights to assets in a bankruptcy. Any loan that has collateral securing it, like an auto loan or mortgage is treated differently.
6. Unsecured consumer loans fall under the Fair Debt Collection Practices Act
Unsecured consumer loans like credit cards are covered under the FDCPA and the consumer is offered some protection from the behavior of collection agencies should the loan default. For example collectors can not make harassing calls, call you at work, threaten law suits when they have no intention to sue and a host of other restrictions. The law also allows to sue collectors who violate the act and the consumer can receive up to $1000 plus attorney’s fees.
7. Know your numbers
Because the only thing backing unsecured loans is your promise to pay it back, lenders will obviously want to see your credit report and FICO score when considering your application. The better the credit history and the better the FICO score the better position you are in to negotiate a lower interest rate. Federal law allows you to get a copy of your credit report free once a year. Download it from the free site and review it for accuracy. If there are errors, resolve those with the reporting agency before applying for a loan. The better financial profile you can present the less the loan will cost you.
Unsecured loans have their place but it is imperative you understand the terms and conditions before you sign. Always deal with a reputable lender when seeking out these types of loans. Selecting the wrong lender could end up costing you thousands.