Unsecured Personal Loans: Benefits & the Hidden Risks
Personal loans offer a way to secure the funding needed for many of life’s significant or unexpected expenses, but they are not all created equal. Secured personal loans and unsecured personal loans are two common types of financing, and both viable options for borrowers under different circumstances. However, unsecured personal loans come with unique benefits as well as some hidden risks consumers should be aware of before signing on the dotted line. Let’s start with a brief comparison of unsecured personal loans and secured loans.
Comparing Benefits of Unsecured Personal Loans to Secured Loans
Unsecured personal loans and secured personal loans make up the majority of the loan market today. Borrowers have the option to take out a loan using collateral – an asset like a bank account or valuable possession such as a vehicle – to back the loan. Pledging collateral means that the lender offering the loan can recoup any losses for non-payment by acquiring and then potentially selling the asset. Loans structured in this way are secured personal loans.
Benefits of Secured Personal Loans
Secured personal loans provide some distinct benefits to borrowers, including:
- Lower interest rate due to the lower risk of financial loss.
- Easier qualification for a new loan.
- Lower fees for loan funding or application.
Benefits of Unsecured Personal Loans
While secured personal loans come with some advantages, many consumers are drawn to unsecured personal loans for a variety of reasons.
Unsecured personal loans do not require collateral, but instead, the ability to get approved for one is based on a borrower’s credit history and financial standing. Most lenders take a close look at credit report and income to determine if an unsecured personal loan can be approved. However, there are a handful of lenders that do not require strong credit scores to be eligible for a loan. In these cases, borrowers need to be aware that the higher risk taken on by the lender equates to a higher cost of borrowing.
Advantages of Unsecured Personal Loans
Borrowers gain several benefits in using an unsecured personal loan, not the least of which is the ability to get financing without the need for posting some form of collateral. Lenders do not need to have a vehicle or a bank account waiting in the wings in case of default on loan, so borrowers do not need to be concerned about giving up an asset.
Besides, unsecured personal loans also offer the following advantages:
- A fast decision on approval, typically within one to two business days if not immediate.
- Quick funding, with a deposit of loan funds in a few days.
- Potentially lower cost for borrowing compared to credit cards and payday loans.
- The ability to repay the loan over the course of several months or years.
- A predictable, fixed monthly payment.
- A fixed interest rate and known cost of borrowing.
Unsecured personal loans are also available from several different lenders. Online loan providers, banks, and credit unions may offer unsecured loans after a borrower completes a brief application, often done online.
The Risks of Using an Unsecured Personal Loan
Although the advantages of unsecured personal loans make them attractive for many borrowers, there are risks involved. The most notable risk of an unsecured personal loan is the potentially high cost of borrowing.
The expenses associated with an unsecured loan include:
- An application fee.
- A funding fee or origination charge.
- Pre-payment penalties.
- The interest rate.
While these costs vary from one lender to the next, they can add up quickly. Origination, funding, and application fees equate to an up-front cost for borrowing, taking away how much of the loan proceeds actually make it to the borrower.
High-interest rates on unsecured personal loans reduce the benefit of getting access to financing over the long term as well, especially when rates are in the high double digits. Depending on the size of the loan, borrowers could pay hundreds to thousands of dollars above the amount they received in interest charges.
Borrowers also face hidden risks when taking out unsecured personal loans when it comes to their credit. Most lenders perform a hard credit check when a loan application is submitted, which can bring one’s credit score down. However, the biggest credit risk revolves around non-payment of the loan.
If a borrower missed a payment, is more than 30 days late on a monthly payment, or fails to repay the loan amount in full over time, lenders report these issues to the Credit Bureaus. This creates a negative payment history, which can drop a credit score down significantly.
Unsecured personal loans also present an opportunity to borrow too much. With secured personal loans, a borrower is only able to get approval for a loan up to the value of the collateral. For instance, if a savings account with $5,000 is used as collateral, a loan of up to $5,000 may be available, but no more.
Unsecured personal loans can be for a few thousand up to $35,000 or $40,000, depending on the lender and credit history of the borrower. Taking out much more than is necessary leads to a higher monthly payment and higher cost of borrowing.
Breaking Down the Pros & Cons of Unsecured Personal Loans
Having access to an unsecured personal loan has many benefits, but these must be weighed against the risks. The table below breaks down the pros & cons for easy comparison.
|Monthly Payment||Predictable and fixed||Could put a strain on a monthly budget|
|Interest Rate||Potentially lower for good to excellent credit borrowers||In the high double digits for bad credit borrowers|
|Application||Easy to complete with any bank, credit union, or online lender||Submitting an application requires a hard credit check|
|Collateral||No need to pledge assets to back the loan||Higher cost of borrowing because no collateral is used|
|Credit||On-time payments help maintain/strengthen credit score||Late, or missed payments result in a reduced credit score and negative marks on the credit report|
Unsecured personal loans have definite benefits. Getting such a loan is simple and you don’t have to put your assets under the risk. It’s a perfect choice for people who wants to stay safe and want to borrow money quickly and easy.
Regarding the risks, borrowers opting for unsecured loans have to keep in mind higher interest rates and loan payments. Depending on your credit score, this loan can cost you pretty much.
Overall, using unsecured personal loans can be advantageous for borrowers who understand both the benefits & the risks.
“8 Possible Risks of Unsecured Personal Loans” – https://www.investopedia.com/articles/personal-finance/111815/8-possible-risks-unsecured-personal-loans.asp
“The Pros and Cons of Unsecured Personal Loans” – https://smartasset.com/personal-loans/the-pros-and-cons-of-unsecured-personal-loans
“Secured and unsecured personal loans: What’s the difference?” – https://www.creditkarma.com/personal-loans/i/unsecured-personal-loan/
“Secured vs. Unsecured Loans: What You Should Know” – https://www.experian.com/blogs/ask-experian/secured-vs-unsecured-loans-what-you-should-know/
Melissa is a financial literacy professional who is passionate about educating individuals and business owners about the power of smart money management.
She has used her undergraduate degree in finance and her MBA in marketing to establish a comprehensive financial planning firm serving clients in Washington, DC and the surrounding area.
During her 13 years in the financial services industry, Melissa has taught thousands of clients how to create and sustain financial freedom through better understanding what their money has the potential to do for them. In addition to working with clients, Melissa contributes financial literacy and money management articles for several publications across the web.
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