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Signature Loans: Pros and Cons

By Selena Maranjian - Updated Feb 14, 2017 at 3:58PM

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Does a signature loan make sense for you?

If you're looking to borrow money, "signature loans" are one kind of loan that might be suggested to you. Signature loans have some appealing aspects, but learn more about them before signing up for one -- because they have some significant drawbacks, too.

Signature loans: the basics
A key characteristic of any loan is whether it's secured. A mortgage, for example, is secured by the home it's helping you buy. The home is the collateral. If you default on the loan, the lender can claim the property.

Credit card debt, meanwhile, is not secured. If you fail to pay what you owe, the lender can come after you or sic a collection agency on you, but it's not likely to repossess anything. Signature loans are unsecured loans.

Signature loans have also been called "character loans," or "good faith" loans, because they involve a lender -- typically a bank or credit union -- lending money based on your character, your relationship with the lender, and just your signature and promise to repay. They typically feature a fixed-interest rate, too.

Signature loans: upsides
When assessing the pros and cons of signature loans, a big upside is that they can be fast and convenient. The interest rates that lenders charge will generally be higher than secured-loan rates because the lender is bearing more risk; but they'll still likely be lower than another unsecured option -- the payday loan.

The fact that the loan is unsecured is another plus for the borrower, because it means you're not putting any property at risk. Signature loans can be perfect for some people -- if, for example, they want to consolidate a bunch of debt that carries steep and variable interest rates, such as credit card debts.

Signature loans: downsides
Of course, there are downsides, too. Not everyone is well served by signature loans. They involve credit checks, for starters, which means if your credit rating isn't very good, you won't get an attractive interest rate – and you might not be offered the loan at all.

Even a good rate due to a good credit score is likely to be higher than rates you might get with secured loans. So if you own a home, you might want to consider a home equity loan instead.

Signature loans tend to be for relatively short terms, sometimes for one or a few months, and generally no more than four or five years. If you need to borrow $50,000 or $100,000, you're probably out of luck, too, as they tend to be for sums in the $3,000 to $35,000  range. (Again, this is because the loan is unsecured and the lender is bearing a lot of risk.)

Sometimes, you'll have to have a cosigner on the loan, too. This reduces the lender's risk, as it can go after the cosigner if you default on the loan.

What to do
If you think a signature loan might be for you, look into it more. Collect some quotes from your preferred lenders, but don't go crazy. Remember that each quote will likely require a credit check, which will be noted on your credit report, and can temporarily decrease your credit score.

If you have a poor credit rating right now and you can put off taking out the loan, you might opt to build up your score for a year or so, such as by paying bills on time and getting your ratio of debt to total credit limit down.

Finally, you can probably get a better interest rate by not letting the loan be for too long -- the longer it is, the more risky it is for the lender -- and by not borrowing too little, as lenders often view smaller sums as less likely to be paid back. Plus, larger loans will generate more income for the lender.

Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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