Updated July 14, 2023
Introduction to Unsecured Loans
The security of any collateral does not back up unsecured loans associated with such borrowings. As such, if the borrower defaults on the loan repayments and interests, then the lender can’t realize any assets to make good the defaults. The banks and other financial institutions grant these loans to lenders based on their credit scores, credit history, and income levels.
The loans are broadly divided into two types, namely secured loans and unsecured loans. The secured loans are the ones that are backed up by the security of any collateral; so, if the borrower is unable to repay any installment of the loan or interest, the same can be realized by the lender using the assets collated from the borrower. But in the case of unsecured loans, if the borrower cannot repay the loan amounts, the lender has no right to realize it with the borrower’s personal property. Thus, as the name suggests, these types of loans are not secured. Banks give such kinds of loans to their customers on behalf of their credit score, trust, and capability to pay. The interest rate in unsecured loans is comparatively higher than in secured loans.
How Does it Work?
Any security or collateral does not back up unsecured loans, so such loans charge a high-interest rate from the borrower. Bank tries to ensure that such loans are given to only those with high creditworthiness. For this, the bank first checks the borrower’s credit history willing to take a loan, and after going through the credit history, the borrower’s credit scorer is analyzed. It is the credit score that helps the bank in deciding whether to grant a loan or not. If the borrower’s credit score is good, there is more chance of a loan grant or vice versa. A borrower’s credit score can improve, so the borrower should remember to improve his credit score before applying for a loan. The next thing the bank checks is the potential of the borrower to repay, which can be checked through income proofs.
Examples of Unsecured Loans
- Personal Loan: These types of loans grant to fulfill the borrower’s personal needs. There is no need to pledge any security or collateral, but the interest rate is high.
- Travel Loan: The borrower can take a loan to travel. The lender checks the credit score and ability of the borrower and provides them with a loan if they find them trustworthy.
- Credit Cards: Banks issue credit cards for their customers with good credit scores and past fair transactions. The bank regularly bills borrowers to utilize the amount for making payments, which they must repay.
- Student Loans: This type of loan gives to students who want higher education without any security or collateral.
Types of Unsecured Loans
- Term Loan: In term loans, the borrower has to pay equal installments until the loan is paid off. These types of loans are for certain fixed tenures.
- Revolving Loan: In a revolving loan, a credit limit gives the borrowers to spend until the credit limit is exhausted. The borrower would require to repay the same interest to the bank and spend it again since the limit gets replenished again. Credit cards are an example of such types of unsecured loans.
- Consolidation Loan: A consolidation loan is to pay off the existing loans. A borrower taking such types of loans must pay a fixed interest rate, and the repayment terms are also fixed.
Unsecured Loan Interest Rate and Charges
A bank uses the interest on loans to pay off the interest on the deposits, and this cycle continues. The bank started giving loans without security or collateral to encourage more borrowers to take loans. For this, the bank charges a high-interest rate as such types of loans are risky for the bank as there is difficulty in realizing the loan amount. So, its interest rate is higher than secured loans’ interest rate. Also, the interest rate varies depending upon the type of unsecured loan the borrower is willing to take, as well as the tenure of the loan.
The bank also takes some fees or charges on unsecured loans like interest rates, processing fees, EMI bounce charges, penal interest, and secure fees (for online approvals if the borrower is taking a loan online).
Who Should Get Unsecured Loans?
Anyone with a good credit score and solid income proof can take an unsecured loan. The lender would check these few things before granting them a loan:
- Capacity: The lender would check on the borrower’s capacity as to whether they can repay it or not.
- Past Defaults: The bank or the lender would check on the past transactions of the borrower to see if there are any defaults.
- Current Conditions: The last thing the lender or bank would check is the current condition of the borrower to know whether the borrower would be able to pay off the debt in the future.
Some of the benefits are given below:
- The High Rate of Interest: The bank or institution charges a high interest rate against the loan given as there is no security which can be a high income for the bank.
- More Loans Can be Provided: With the help of unsecured loans, the bank can attract more borrowers as there is no need for collateral.
- No Need for Collateral: Such loans are given without any need to give collateral assets, making it easy for borrowers to take a loan.
Some of the disadvantages are given below:
- Risk Factor: There is a high level of risk in unsecured loans as the lender can’t use the buyer’s property to repay the loan amount.
- Credit Score: A loan is only given to the borrower according to the credit score; if the borrower’s credit scorer is not good or faulty, no loan will be granted.
- Limited Amounts: A borrower can take a loan only up to a specific limit, and if the borrower wants to get extra, then collateral assets are required.
Unsecured loans are very beneficial for the borrower as well as the lender. This is because borrowers get loans without collateral for their assets, which helps earn a huge interest rate for the lender. However, unsecured loans are risky asset classes for banks and other lenders.
This is a guide to Unsecured Loans. Here we also discuss the definition and how does it work? Along with benefits and disadvantages. You may also have a look at the following articles to learn more –