What is an unsecured loan? (2023)
An unsecured loan doesn’t require collateral. Learn about how this kind of loan works, the types and what to consider before getting one.
Sara Coleman
Every loan involves a level of risk for both the lender and the borrower. One way a lender can lessen its risk is by requiring collateral from the borrower. However, borrowers can also benefit since offering up collateral can increase their likelihood of approval.
Collateral is an item of value that serves as security for a loan, which means the lender can seize the asset to sell if the borrower doesn't repay the debt. This gives the lender additional financial protection, making them more willing to lend to a borrower who might not qualify for an unsecured loan.
Personal loans provide upfront funding for borrowers to use for a number of purposes — like home improvement projects, for instance, or consolidating credit card debt. As the borrower makes on-time payments of principal and interest, the lender recoups the initial loan amount and earns a profit from collecting interest. It can then use those funds to offer loans to other borrowers.
But there’s a downside for lenders: there’s always the risk a borrower won’t repay their debt, which means a loss for the lending institution. Collateral helps lessen this risk by giving lenders an alternative to collecting the funds they’re owed.
Loans that require collateral are called secured loans. If a borrower defaults on a loan (meaning they miss payments or stop making payments altogether), the lender can take possession of the collateral and sell it to regain the loss. A lender may require the collateral value to be as equal to the loan value as possible, although this requirement varies depending on the lender’s policies.
“Lenders like collateral-backed loans because it’s less risky to them,” said Jeanne Kucey, the CEO of JetStream Federal Credit Union. “The borrower, however, risks seizure of their collateral if they miss their monthly payments. For instance, a vehicle that is used for collateral will generally be repossessed after three or more missed loan payments. The borrower can usually redeem the repossessed vehicle, but there will be additional fees, a big hit to their credit score and a loss of transportation.”
You can use many different types of assets as collateral for a loan, including the following.
When you close on a mortgage, you’ll sign a deed of trust or a mortgage (depending on your state’s laws) that names the property as collateral for the loan. This lets the lender create a lien on the property, which gives it an ownership claim until you pay the loan in full. If you default, the lender could foreclose and sell the property. This same process applies to a home equity line of credit (HELOC) or home equity loan.
With an auto loan, the vehicle you're purchasing is the collateral. If you fail to make your car payments, the lender has the legal right to repossess the vehicle and sell it. You can use cars as collateral for personal loans and other financing types, though this depends on lenders’ minimum equity requirements — depending on the vehicle's current value and how much you owe, you may not be able to use it as collateral.
Lenders like collateral-backed loans because it’s less risky to them. The borrower, however, risks seizure of their collateral if they miss their monthly payments. ”
You can pledge savings accounts, money market accounts or certificates of deposit as collateral. Your lender may require a minimum balance to qualify, though.
You can use investments in securities such as stocks or bonds as collateral for loans.
Other forms of potential collateral include precious metals, art, jewelry and valuable collectibles. Determining the actual market value of these items is sometimes more difficult than other forms of collateral (like cash accounts), which can make it more difficult to use them as loan security.
Most lenders do not allow the use of retirement accounts, such as 401(k)s and individual retirement accounts (IRAs). Additionally, some lenders may not accept vehicles over a certain age as collateral for an auto loan.
» MORE: Secured vs. unsecured loans
Secured loans may be more common than you realize, including some of these examples of popular collateral-backed loans:
» MORE: How to stop foreclosure
As a general rule, you’re likely to get a lower interest rate with a secured personal loan than with an unsecured one. Keep in mind that even a slight reduction in the interest rate could save you a significant amount of money over the life of the loan.
“If you’re confident that you can make your payments on time and want a lower rate, collateral will be your best option,” Kersey said. “If you don’t have collateral available, you might still be able to get an unsecured loan at a reasonable interest rate if you have a high credit score and a low debt-to-income ratio.”
You can typically get your collateral back once you’ve paid the entire financial obligation.
Yes, you can use cash from a savings account or a future paycheck as collateral, depending on the type of secured loan you’re applying for.
You may have the option to use collateral in someone else’s name; however, the lender will likely require proof of permission to use it.
Yes, you can apply for an unsecured loan, which is guaranteed by your signature instead of an asset. Lenders see these loans as riskier, which is why the interest rate is typically higher and there are more strict credit and income requirements for approval.
Collateral is an item of value that’s pledged as security for a loan. Secured loans, like mortgages and auto loans, require collateral. While there are a few companies that offer secured personal loans, most personal loans don’t have a collateral requirement, which is why they often have higher interest rates.
Lenders ask for collateral because it lessens their risk of financial loss, but borrowers need to be aware of the risks associated with pledging collateral: If you fail to make payments, the lender can take possession of the item and sell it. Make sure you weigh the benefits and downsides of both secured and unsecured loan options before deciding on the right loan for you.
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