Personal Loans Are Unsecured. Here's What That Means for You as a Borrower

U.S. personal loan balances have been growing. As of the first quarter of 2023, they came to $225 billion, which represents a 26.3% uptick from one year prior, says TransUnion.

You may be interested in a personal loan because these loans allow you to borrow money for any purpose. And their interest rates can be far more competitive than what a credit card will charge.

But it's important to have a good credit score as a personal loan applicant. If you don't, you might struggle to get approved -- or get approved at an interest rate that's affordable to you.

It's all about mitigating risk

Personal loans are a type of unsecured loan. This means that these loans are not tied to a particular asset. It also means personal loan lenders take on their share of risk by not having any sort of collateral for the loans they write.

By contrast, mortgage loans are secured. If you don't repay your mortgage, your lender can eventually force the sale of your home to get repaid. So in that regard, your lender has some recourse.

Since mortgage loans tend to be large (after all, they're being used to finance the purchase of a home), lenders still impose certain standards when it comes to borrower credit scores. And if your credit score isn't great, you might struggle to get approved for a mortgage, or get approved at a competitive rate.

But it's easy to argue that personal loan lenders take on even more risk because there's no specific asset to reclaim should a borrower fall behind on their payments. As such, if you don't have good credit, you might struggle to get approved for a personal loan because your lender might worry that you're not in a good position to repay that money.

Now, there are personal loans out there for borrowers whose credit isn't the best. But if you fall into that category, you might end up with a higher interest rate on your loan than you want, thereby negating the affordability factor personal loans are known for.

Try to raise your credit score before applying for a personal loan

Your chances of getting approved for a personal loan -- and qualifying for a good interest rate on one -- are higher if you have strong credit. So it pays to do what you can to boost your credit score before applying for a personal loan. You can do that by:

• Paying all incoming bills and debts on time
• Paying off a portion of your credit card balance, especially if you're currently using more than 30% of your total credit limit at once
• Avoiding applying for new credit cards for the time being
• Reviewing your credit report for errors, and correcting mistakes that paint you in an unfavorable light

A personal loan could be a great way to borrow money when you need to. And the higher your credit score at the time of your application, the greater your chances of getting approved and winding up reasonably happy with the interest rate you qualify for.