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What Is an Unsecured Loan?

Kat TretinaPublished on

unsecured loan

If you’re thinking about applying for a student loan or refinancing loan, you may have come across the term “unsecured loan” while doing your research. It’s a very common financial term describing a particular form of credit. But what is an unsecured loan?

Unsecured loans don’t require collateral — an item of value that guarantees the loan. Instead, the lender issues you a loan based solely on your creditworthiness. Below, find out how unsecured loans work and how to qualify for one.

What is an unsecured loan?

With a secured loan, you have to put something of value down as collateral. For example, when you take out an auto loan or home loan, your car or house serves as collateral on the loan. If you fall behind on your payments, the lender can take and sell your property to offset their costs. Secured loans tend to have the lowest interest rate of any loan, because there’s less risk to the lender.

Unsecured loans work differently. They don’t require any form of collateral. Lenders review your loan application and decide whether or not to issue you a loan based on your credit score, income, current debt, and other factors.

Because there is no collateral, unsecured loans pose more of a risk to lenders. As such, unsecured loans tend to have higher interest rates than secured loans. However, if you have good to excellent credit, you can still qualify for relatively low interest rates.

Just because a loan is unsecured doesn’t mean that there are no consequences if you miss payments; it just means that the lender can’t seize your property. Instead, they can take measures like sending you to collections, or, in the case of some student loans, even garnish your wages.

Requirements for unsecured loans

Unsecured loans are very common. If you’re thinking of taking out federal or private student loans or want to refinance your student loans, you’re dealing with unsecured forms of debt.

Both student loans and refinancing loans are installment loans. That means you have a set repayment period and you make monthly payments until the debt is paid off.

When issuing private student loans and refinancing loans, lenders want to make sure you’ll repay the debt. Before approving your application, the lender will look at a range of factors to determine if they should issue you a loan, and, if so, what the interest rate should be:

  • Credit score: Your credit score is a three-digit number that indicates how responsible of a borrower you are. The higher the number, the better your credit. Lenders often have minimum credit score requirements of around 650 or higher for loan candidates.
  • Income: Lenders will look at your income to determine whether or not you can afford the loan payments. Some lenders have income minimums. For example, you can compare the income minimums for Purefy’s student loan refinance lenders here.
  • Debt-to-income ratio: Your debt-to-income (DTI) ratio is the amount of your monthly income that goes toward debt payments. Most lenders will have a maximum DTI ratio that you can’t exceed in order to qualify.
  • Loan term: The loan term you choose can significantly impact your interest rates. In general, the longer the loan term, the higher the interest rate will be on your loan.

Co-signers and unsecured loans

Because unsecured loans don’t require collateral, lenders face more risk. To minimize the chances of losing money, lenders set out strict underwriting requirements. If your credit is less-than-stellar, or if you’re just starting out and have insufficient income, you may not qualify for a loan at all. Or, if you do, you might get stuck with a high interest rate.

That’s when having a co-signer can be a big help. Your co-signer — usually a friend or relative with good credit and stable income — agrees to make payments on the loan if you fall behind. With unsecured loans, adding a co-signer to your application lessens the risk to the lender, increasing your chances of getting approved for a loan and qualifying for a low interest rate.

Having a co-signer on your student loan or refinancing loan can result in significant savings. For example, let’s say you took out $30,000 in private student loans with a 10-year repayment term. If you applied on your own, you might qualify for an interest rate of 9%. Over the course of your loan term, you’d repay a total of $45,603.

But let’s say you applied for a loan with a co-signer who had excellent credit. You could qualify for a 10-year loan at just 6% interest. Over your repayment term, you’d pay just $39,967. Adding a co-signer to your application would help you save over $5,600.  

 

Without a co-signer

With a co-signer

Loan term

10 years

10 years

Loan total

$30,000

$30,000

Interest rate

9%

6%

Monthly payment

$380

$333

Total paid

$45,603

$39,967

Total interest

$15,603

$9,967

When it comes to unsecured forms of credit, like student loans and refinancing loans, adding a co-signer can be a great way to save money over the length of your repayment.

Shopping for an unsecured loan

Student loans and refinancing loans are unsecured loans, so you don’t have to worry about putting up any valuables as collateral. Because unsecured loan lenders base their decisions and interest rates on your creditworthiness, it’s a good idea to shop around and compare offers from multiple lenders to get the best rates. Use Purefy’s Find My Rate tool to get quotes on private student loans and refinancing loans.