Understanding Unsecured Loans
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Do you need some extra cash to pay for an unexpected expense? Maybe your hot water heater broke down, or your car needs a new transmission. In emergency situations, an unsecured loan — also known as a personal loan — could help you get the money you need quickly.
People also use unsecured loans to pay for luxuries such as a wedding or dream vacation. They like the stability of monthly payments that don’t change, and the knowledge that the loan will usually be paid off in two to five years, depending on the loan terms. Credit card debt, on the other hand, can persist for decades if you make only the minimum monthly payment.
In fact, the majority of people who take out personal loans do so to pay down other debt. In 2018, 39.2% of personal loans were to consolidate debt, while another 21.8% were to refinance high-interest credit card debt.
Personal loans are one of the fastest-growing types of debt in the U.S., with 19.5 million loans spanning $125.4 billion in personal loan debt.
People take out unsecured loans for many reasons, but are they the best choice to cover expenses?
What is an unsecured loan?
Unsecured loans are loans that are not backed, or secured, by collateral such as a house, vehicle or savings. Collateral is any property that the lender can repossess if you default on the loan.
When you take out an unsecured loan, your credit is at stake. Lenders can report your late payments to the three credit bureaus, which can put a negative mark on your credit history and potentially lower your credit score, making it harder for you to get credit at low interest rates in the future.
Unsecured loans are riskier for lenders than they are for borrowers, which is why they often come with higher interest rates.
But if you have a credit score of 640 or above, a low debt-to-income ratio and a steady income, you may qualify for single-digit interest rates lower than the interest rates offered by many credit card providers.
Breaking down unsecured loan options
Borrowers have a few options when it comes to unsecured loans. The interest rate, payment terms and even the maximum you can borrow may vary based on the type of loan and the specific lender.
A personal loan permits you to borrow money, typically ranging from $1,000 to $50,000, and pay it back over a predetermined period. Most forms of personal loans are unsecured.
Personal line of credit
A personal line of credit is similar to a credit card, and is considered a form of revolving debt. Typically extended by banks, a personal line of credit permits you to borrow what you need up to a certain amount.
Lenders determine your credit limit based on your credit score, credit history, income and debt-to-income ratio. Your monthly payments will vary based on how much you borrow each month.
Because it is there when you need it, a personal line of credit can offer a sense of financial security and help with emergency expenses. Interest rates on personal lines of credit are typically lower than with credit cards, but you won’t enjoy the same rewards that top-tier credit cards offer.
How to get an unsecured loan
So, you’re in the market for an unsecured loan. What are the first steps?
Before you consider any loan or line of credit, it’s a good idea to check your credit score and pull your credit files to see if there are any mistakes or areas for improvement.
Keep in mind, 24% of prospective borrowers in 2017 were denied at least once for their requested loan amount before getting a personal loan. You’ll want to do everything in your power to ensure you’ll get approved on your first attempt.
To obtain your best rates on a personal loan, make sure you have no late payments in your recent past. If you do, it might be best to wait a few months before applying for a loan to improve your odds of approval and get a better interest rate.
You’ll also want to evaluate your debt-to-income ratio, a key statistic that lenders evaluate when determining if a borrower is a good credit risk. Most lenders want to see a debt-to-income ratio of less than 36% for all types of debt other than your mortgage. If you own a home, your total debt including your mortgage should not exceed 43% of your income.
Once your credit appears to be in good shape, determine how much money you need and how long you want to borrow. The longer the term of the loan, the lower your payments, but shorter-term loans often have lower interest rates.
When you compare loans, be sure to consider the interest rate and any loan origination fees, prepayment penalties, application fees and other costs associated with the loan.
Alternatives to unsecured loans
Despite their popularity, unsecured loans may not be the best choice for everyone looking for extra cash.
Unsecured personal loans are best if you have good-to-excellent credit, no collateral (such as a home) to borrow against and need a small-to-moderate amount of money quickly.
You might consider these alternatives.
Home equity loan
When you take out a home equity loan, you’re using your house as collateral to borrow money. Home equity loans often have closing costs, appraisal fees and other costs associated with them, but because the interest rate may be as low as mortgage interest rates (or even lower), you’ll save money in the long run.
Home equity loans are good if you want to borrow a large amount of money over a long period.
Home equity line of credit
A home equity line of credit, or HELOC, also taps into your home’s equity — that is, the difference between your home’s value and what you owe on your mortgage. You don’t take this money in one lump sum, though. You borrow it as needed and pay it back, with interest, in payments that vary depending on how much you borrowed.
Secured loans permit you to put your savings, certificates of deposit or even your vehicle title up as collateral to borrow money. If you have money tied up in a CD and don’t want to face early withdrawal penalties, you might consider taking out a secured loan so you can keep your money in the bank.
Most people can qualify for a secured loan as long as they have the appropriate collateral.
If you have good-to-excellent credit and need money for a short-term expense, consider applying for a credit card with a 0% introductory APR. You’ll save on interest costs during the introductory period and might even earn rewards on your purchase or balance transfer.
The bottom line
An unsecured personal loan isn’t for everyone. But for increasing numbers of Americans, an unsecured loan is a smart solution to diversify your credit file or pay off higher-interest debt.
To find your best personal loan, make sure your credit reports are in the best possible shape, and then shop around for the lowest rates.