There are many financing options for consumers who want to borrow money All of these alternatives fall into two lending categories: secured and unsecured debt. Personal loans are almost always unsecured. For this reason, personal loans are often called unsecured loans or signature loans.
What Are Secured Loans?
When a loan is secured, the lender requires the borrower to pledge something of value that the lender can take if the borrower fails to repay the loan. This item is called "collateral" or "security."
Often, the collateral is the item being financed. For example, if you take out a mortgage to purchase your home, the home itself serves as the collateral. The lender can foreclose, evict you and sell the house if you fail to make your payments. Similarly, if you borrow to buy a car, the car itself is the collateral for that loan.
What Are Unsecured Loans?
Unsecured loans have no collateral. There is no property for the lender to recover if you don't repay the loan. Because of this additional risk, unsecured loan interest rates are higher than secured loan interest rates. The lender's main form of security is your good word -- your personal promise to repay.
What is a signature loan? It's just another name for a personal loan or unsecured loan. You signature is the lender's only guarantee of repayment. Most unsecured loans have shorter terms than secured loans. While you can get a mortgage for 30 years, personal loans typically have terms ranging between one and five years.
Common Traits of Unsecured Loans
There are some characteristics nearly all unsecured loans share:
- They provide a lump sum that you repay in monthly installments.
- Interest rates are generally fixed.
- You can use the money for any legal purpose.
- While you can find personal loans in amounts ranging between $1,000 and $100,000, the most popular sources offer a range between $5,000 and $35,000.
Personal Lines of Credit
Personal lines of credit are also unsecured. The difference between a personal line of credit and a personal loan is that the line of credit is open-ended. It has no preset term.
With a line of credit, your lender approves a specific maximum amount, and you may draw any amount at any time, up to your limit. Your monthly payment depends on your interest rate and current balance. Most lines of credit have variable interest rates. This can make budgeting a little harder than with fixed-rate personal loans.
Credit cards are similar to personal lines of credit in that you can use and re-use them as long as you make your monthly payments.
When should you choose a line of credit over a personal loan? When you don't need all of the money at once. Lines of credit can provide flexibility. They can be a great source of emergency cash that you only tap if necessary.
Student loans are technically unsecured. That's because even though you use them to acquire an education, the lender can't rip the knowledge out of your head or repossess your degree if you default.
One advantage of student loans is that in some cases they may be forgiven. If, for example, you get a teaching degree and go to an at-risk district.
Personal loans differ from private student loans in that you can spend the money any way you choose. So you can pay your tuition with a personal loan, but also fix your car if it breaks down. Or take a Spring Break trip.
Personal loans differ from government-backed student loans in that your repayment can't be deferred until you graduate or restructured according to your income. But you can discharge them in bankruptcy if you get in deep financial trouble. Government-backed student loans are nearly impossible to discharge in bankruptcy and can follow you for life.
Where Do You Find Unsecured Loans?
There are many types and sources of unsecured financing. Here are the top six:
Your local bank. If you have excellent credit and a good relationship with your local bank, you might get a signature loan within hours.
Online lenders. Probably the best way to shop for and compare personal loans is with online sources. You can fill out a form, see your offers and choose the one with the lowest costs.
Peer-to-peer (P2P) sites. P2P lenders are popular sources of personal loans. The lenders can be individuals and also institutions. In most cases, these loans come with fixed interest rates and payments.
Student loans. Your school's financial aid office is a great place to start your search. You can also find sources online.
Credit cards. Credit cards have lower barriers to entry than personal loans. There are cards for people with bad credit and people with no credit. There are rewards cards, balance transfer cards, business credit cards and store cards. Credit cards have a lot of fine print and ignoring it can be costly.
Personal lines of credit. The terms of personal lines of credit can be complicated. Your interest rate is likely to be variable, and you'll want to know how the rate is set and under what circumstance it can increase.
What Credit Score Do You Need for a Personal Loan?
Because lenders rely only on your promise to repay, your credit rating is extremely important when you apply for a personal loan.
How much does your credit rating affect the interest rate you pay? A lot. FICO's Credit Score Calculator shows what a consumer with excellent credit would pay as of this writing.
- FICO score: 760
- Mortgage rate: 4.012%
- $25k personal loan rate: 7.70%
And this is what a consumer with fair credit would pay:
- FICO: 660
- Mortgage rate: 4.625%
- $25k personal loan: 12.76%
Note that the difference between personal loan interest rates is over 5%, while the difference between mortgage rates is just .63%. That's the difference being unsecured makes to a lender.
How Much Income Do You Need for a Personal Loan?
To get a personal loan, lenders look at the relationship between your income and your debts. This relationship is called your dent-to-income ratio, or DTI.
You calculate your DTI by adding up your housing costs (rent or mortgage principal, interest, taxes and insurance), installment loans like auto financing and student debt and the minimum payments on all of your credit cards. You don't count living costs like food and utilities. Next, divide that total by your gross (before tax) monthly income.
Suppose that you earn $5,000 per month and pay $1,000 for rent. You have a $500 car payment and $250 in credit card minimum payments. Your DTI is ($1,000 + $500 + $250) / $5,000. That's $1,750 divided by $5,000, which is .35 or 35%.
Most personal loan providers set maximum DTIs at about 40%. Some will go as high as 50% for the right borrowers. So, if you wanted to borrow as much as possible, how much could you get?
Multiple $5,000 by .5 to get $2,500. Subtract $1,750 and you have a maximum payment of $750. So you could take any combination of available interest rate, term and loan amount that would give you a monthly payment of $750.
How to Shop for a Personal Loan
Is it hard to get a personal loan? Not if you have a reasonably good credit rating and enough income to support the payment.
But it's very important to shop and compare offers from several personal loan vendors. Personal loan interest rates start at about 6% and go as high as 36% from mainstream vendors.
You'll want to compare loans with the same amount and terms to get reliable quotes.
How to Apply for a Personal Loan
When you apply for a personal loan, you'll complete an application proving personal information, income, debts and assets.
- You'll need to authorize the lender to pull your credit report.
- You will also supply documents proving your income and your identity.
- Lenders will probably ask you for bank statements.
- Lenders may check with your landlord to get your rental history.
- If your credit report contains blemishes, count on explaining them.
You don't normally furnish all of this to get a credit card. But that is why personal loans usually have lower interest rates even though both personal loans and credit cards are unsecured. Personal loan vendors get a lot more information about you.
What Happens if You Don't Repay an Unsecured Loan?
Because personal loans are unsecured loan, you might wonder if you can just decide not to repay them. But just because lenders have no collateral doesn't mean they have no recourse. Unpaid unsecured lenders have four remedies:
- Turn you over to a collection agency.
- Sell your debt and let the new creditor try to collect.
- Report bad payment history to credit bureaus, making it harder for you to borrow in the future - and possibly impact the ability to rent, buy insurance or get a job.
- Your lender can also sue you, obtain a judgment, and use that to garnish your wages, place a lien against your home, or even force you into bankruptcy.
There are many great reasons to apply for a personal loan, but you do have to pay it back.