Are Unsecured Loans Worth It? The Pros and Cons

CNBC reports that the average American has $38,000 in personal debt, not including home mortgages. Taking out loans can be extremely beneficial, and sometimes necessary, depending on your financial needs. Common purchases using loans include new homes, cars, weddings, home projects, or medical bills.

“A personal loan can be a good way to consolidate existing debt, such as credit cards,” says Kathryn Bossler, a financial counselor at the nonprofit GreenPath Debt Solutions.

When applying for an unsecured loan, it helps to have a good credit score to get approval, but it is not completely necessary. We explain the difference between unsecured and secured loans, the pros and cons to unsecured loans, and why you might consider applying for one.

How to Choose a Personal Loan

Shopping for a personal loan isn’t like shopping for a couch. You have to take multiple factors into account. Here are questions to ask yourself, when it comes to personal loans:

  • How much money do you need? Before you apply for a personal loan, evaluate your financial standing and know how much money you really need. If you want a loan for debt consolidation, for instance, take both the debt and the expected interest into account. Make sure the loan amount is reflective of your financial situation. You want to be certain that you can pay it off in time.
  • How quickly do you plan on paying the loan back? Know how long it will take to pay back. If you’re planning to pay it back in six months, you’ll want to calculate how much you’ll have to pay in total.
  • Are you putting down collateral? When you buy a home, the home is the collateral. If you don’t pay your bills, the lender can take back the home. If you need money for a wedding, in contrast, you’ll need a personal loan that doesn’t require collateral.
  • What is your credit score? Lenders will consider your credit history, when you apply for a loan. The better the score, the better chances you’ll have of getting a low-interest loan.

Pros and Cons

There are many benefits to applying for and accepting an unsecured loan, especially when you’re in need of immediate funds. For starters, you get the benefit of consolidating all of your debts and paying one lender. There are other benefits, too. Here are a few:

  • You don’t have to put down collateral. If you can’t pay off your mortgage or your auto loan, eventually you could lose your home or car to the lender. However, with unsecured loans, you get the benefit of not having to put any of your assets on the line.
  • You can get approval within 24 hours. Some loans take weeks to procure, but with unsecured personal loans there are many lenders who offer immediate responses.
  • These loans are more flexible. A lot of factors impact your approval, but unsecured loans have some flexibility. You might need a set amount for a wedding or a business and lenders will take this into account.

If you need funds fast, unsecured personal loans are a good option. However, it’s important to know the cons of committing to an unsecured loan:

  • Unsecured loans typically have high interest rates. This isn’t usually the case for secured loans. For example, the average auto loan rate for someone with a 650 credit score is 7.65% on a new car. Want to know what interest rate to expect? Consider using a personal loan calculator.
  • Personal loans without collateral are smaller. If you’re trying to get a large amount of funds, an unsecured loan isn’t the best option. Because lenders take a bigger risk when they approve them, they typically commit to smaller loan amounts.

Types of Unsecured Loans to Consider

There are two different types of unsecured loans: (1) revolving loans and (2) term loans. Revolving loans are loans that come with a credit limit that can be spent and repaid over and over again. Personal lines of credit and credit cards are the best examples of revolving loans.

A term loan is a loan that establishes a set timeframe and a set amount that needs to be paid off. The most common term loans are student loans, peer-to-peer loans, business loans, and personal loans.

Banks, credit unions, and online lenders offer unsecured loans. The biggest difference between banks and credit unions is that credit unions are not-for-profit and sometimes offer better interest rates than banks.

If you are already a bank customer, however, you might receive benefits from your bank, which may include: access to free credit scores, no extra fees, or easy access to debt consolidation loans. You can also consider online lenders who will be more likely to offer unsecured loans to individuals with bad credit. With online lenders, you can apply online.

Is an Unsecured Loan Right for You?

Secured loans are pretty straightforward. The most common secured loans are car loans and home mortgages. Less common secured loans include savings-secured loans, and title loans. If you’re buying a car, a home, or if you are in need of borrowed money for a vehicle maintenance or repair, you might want to consider a secured loan.

If you’re in need of funds for personal reasons, like a wedding, unexpected business expenses, or medical expenses, you should consider an unsecured loan. Here’s what you should ask yourself when considering if an unsecured loan is right for you:

  • Do you expect to make a large purchase in the foreseeable future? If you have extra savings, then you might not need a loan. Consider how much money you really need. Lenders apply for various reasons: a funeral expense, a cross-country move, a hefty medical bill, or a home remodel.
  • Do you have a lot of debt to pay off? Achieving a debt-free life is a great goal and consolidating can help you reach it. If you have outstanding balances on multiple credit cards, or various loan balances, you might want to consider one lender so you can combine all of your debt. Unsecured personal loan lenders often offer lower interest rates than credit card companies. However, if you are dealing with an exuberant amount of debt (debt that you can’t imagine paying off at any point in the next five years), you might have to consider other options like bankruptcy.
  • Do you have to pay unexpected bills? Life happens. Maybe you broke your back. Maybe you and your partner are choosing to pay for fertility treatments. Maybe you have to have a root canal. For many reasons, you could end up with unexpected bills that you can’t afford to pay off right away. This is a good reason to consider unsecured loans.
  • Do you have to pay business expenses right away? When you start a business, you often take out loans to get the business up and running. Sometimes, there are unexpected costs that require quick funds. An unsecured business loan can be obtained much quicker than a secured business loan.

Whatever you decide, make sure that you ask yourself the right questions before you start shopping and applying for a loan. According to Aaron W. Smith, RFC, AIF, “When looking to obtain a [business] loan, look for the following: the right lender, the lowest interest rate, an institution that has an interest in a business of your type and size with an interest in servicing the various credit and non-credit needs of your company, and financial stability.”

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How to Qualify for an Unsecured Loan

Most unsecured loan applications are approved based on an applicant’s creditworthiness. Since lenders take a bigger risk on unsecured loans, they typically come with higher interest rates. Some lenders require a minimum credit score so check their terms and conditions before applying.

If you have bad or poor credit, you can still get approved for a loan. Lenders like LendingClub will offer loans to those with bad credit. Bad credit is considered 300 to 620, according to FICO. The best score is 800. Not sure of your credit score? You are entitled to one free copy of your credit report every year. You can go through Experian, FICO, Equifax, or a free credit scoring service.

When you apply for an unsecured loan, you should expect to provide the following information:

  • Personal information
  • Background check
  • Credit history
  • Income level
  • Debt amount

Approval will mostly be based on your creditworthiness, which is proof that you are capable of paying back a loan. If you have a higher score, you have a better chance of (a) getting approved and (b) getting a lower interest rate. However, it is possible to get a loan with bad credit. You might have to put up collateral (such as home equity or your car) or use a co-signer who is willing to take a risk on you.

Just know that if you don’t pay your monthly payments to the lender, this could greatly impact your credit score so only apply if you are confident that you can pay it off. Even one late payment can cause your credit score to decrease significantly so make sure you are choosing the right lender. Go to Better Business Bureau to read reviews of potential lenders before you apply.

How to Manage Unsecured Loans

If you aren’t sure if you can pay off the unsecured loan quickly enough, consider taking the time to build up your credit score. This isn’t always possible. If you are preparing for a funeral, you have to pay sudden, upfront costs, but if you are preparing for a wedding, you have many months to build credit before applying for a loan.

Once you get approved for an unsecured loan and know your unsecured loan rates, here are the best practices for managing it:

  • Schedule monthly payments. Most lenders offer online payment methods. To ensure that you don’t miss a single payment, schedule them as soon as you get approved. If you can, set up automatic payments. The monthly fee might be higher than you expected, but it is a set number.
  • Avoid defaulting. Defaulting means you are admitting to your lender that you can’t pay back your loan. If this happens, the lender can put your account into collections and take legal action against you. You would also hurt your credit score so it is best to simply avoid this.
  • Remember why you applied for the loan. Maintaining financial goals is important for obtaining overall financial health.

When you eventually pay off your loan, Matt Frankel, certified financial planner and personal finance expert at The Ascent says, “Continue using just as much money as you had been using to pay down debt — but instead of putting it toward credit card and loan bills, put it into savings or investments.” The goal, ultimately, is to be satisfied with your financial wellbeing.

Preparing to Pay off Your Unsecured Loan

Before you get approved for a loan, start to consider the unsecured debt that you are about to owe. Loaned money is not free money. Loaned money is borrowed, meaning it has to be returned. Add that monthly payment into your budget. If you don’t have a budget yet, get started right away.