What Is an Unsecured Loan?

The personal lending industry has grown tremendously in recent years. Unsecured personal loans can help people get out of debt faster and finance personal expenses without using credit cards. But what is an unsecured loan? Here's a rundown of what you need to know about unsecured personal loans.

What is an unsecured loan?

There are many types of unsecured loans -- but when people talk about "unsecured loans," they're usually talking about unsecured personal loans. These loans are issued by financial institutions (like your bank) to individuals (you). The term "unsecured" simply means that the lender won't seize your car or house if you can't pay -- in other words, no collateral is used to secure the loan. An unsecured loan can be used for virtually any purpose, and it has a fixed number of payments until it's paid in full.

Many borrowers use their loan funds to consolidate other debts, such as credit card debt. Others use unsecured loans to pay for other expenses, like financing medical bills or home improvement projects.

It's easy to see if you qualify for an unsecured loan -- most lenders have a quick personal loan pre-qualification process. If you qualify, you'll be able to see what interest rate, maximum loan amount, and other terms you can expect to receive. If you're not interested in accepting the terms of the unsecured loan, you can walk away.

How to apply for an unsecured personal loan

When you apply for an unsecured personal loan, you'll have to fill out a form with some important personal information about yourself. You'll probably be asked to provide supporting documentation.

Here are some types of documentation you may be asked to bring when applying to an unsecured personal loan:

• Government-issued photo ID. This could be your driver's license, other state-issued ID, or U.S. passport. You may wonder why a lender asks for such personal pieces of identification. Lenders are obligated to make sure that no one else is pretending to be you and taking out an unsecured loan in your name.
• Your Social Security card (or a copy of it). Your Social Security number is the easiest way for a lender to check your credit history and credit score.
• Proof of your income. Bring your most recent W-2s and pay stubs, or 1099s if you're self-employed. Lenders may also want to see your recent bank statements, especially if you're self-employed.
• Your bank's routing number and the account number where you want the unsecured loan proceeds to go. Some lenders offer a discount if you agree to have your loan payments automatically drafted from your bank account, so you'll need this information for this purpose as well. The deposit and payment accounts don't necessarily need to be the same.
• Your last few tax returns. Not all lenders want these, but it's a smart idea to have them available anyway.

How much interest will you pay?

Interest rates for unsecured loans can vary dramatically: One lender might offer unsecured loans with interest rates ranging from 7% to 36%. Unsecured loans can offer a lower interest rate than you'd get with a credit card, but only if you can get a loan with a low interest rate.

These factors that will determine your interest rate when applying for an unsecured loan:

• Your lender's range of interest rates.
• Your credit score. This is the most important factor in determining your interest rate.
• Your other debts, your income, and your employment history.
• The length of your unsecured loan term. All other things being equal, shorter loan terms generally get better interest rates.
• Your loan amount.
• Whether you agree to pay automatically. Many personal lenders offer a small interest rate reduction if you agree to auto-pay your loan payments.

Fees and other costs of unsecured personal loans

Many personal loan lenders pride themselves on charging no fees whatsoever, while others do have various costs associated with them. Here are some fees you may encounter while shopping for an unsecured personal loan:

Origination fees: This is a fee that is charged when you obtain a personal loan. Many lenders with origination fees deduct it from the loan's proceeds. In other words, if you borrow $10,000 with a $200 origination fee, you can expect $9,800 to show up in your bank account.

Prepayment penalties: Although these are quite rare, prepayment penalties do exist. These are fees that a lender charges you if you decide to pay your loan back early. The rationale is that by making a loan, the lender is expecting a certain amount of interest income. Since your lender won't get all of its interest income if you pre-pay, a prepayment fee is designed to somewhat offset that.

Late payment fee: Many personal lenders charge an additional fee when payments are late. Late payments can also lower your credit score. Getting stuck with a late fee and dinging your credit score is a double whammy, so only take on an unsecured loan if you are absolutely sure you can make the monthly loan payment.

Do you need great credit to get an unsecured loan?

No. There are several personal loan lenders that specialize in loans to consumers with average credit scores. For example, personal loan lender
Avant accepts borrowers with poor credit and higher. Other lenders such as Upstart and Lending Point also accept borrowers with so-so credit scores.

To be clear, you aren't likely to get a single-digit interest rate on your unsecured loan unless you have good credit. However, personal loans can still be great financial tools for borrowers with less-than-excellent credit scores.

Can an unsecured loan be good for your credit score?

Yes, an unsecured loan can boost your credit score. Usually, credit bureaus see personal loans as "better" than credit card debt. So shifting your debts from credit cards to personal loans can significantly boost your credit score. If you're using an unsecured loan to consolidate credit card debt, you might see your credit score improve.

As a personal example, I obtained a personal loan a few years ago to consolidate a few credit card balances. Although the dollar amount of my debt didn't change, my FICO® Score shot up by 30 points shortly after the loan was completed.

Unsecured personal loans vs. credit card balance transfers and 0% intro APR offers

An unsecured loan can be a smart way to consolidate credit card debt and pay for personal expenses. However, it's not your only option. For example, there are several credit cards on the market that offer promotional 0% intro APR periods of 18 months or more.

So, what is an unsecured loan? It's a loan that allows you to pay for projects that need to be completed, to consolidate debt, and -- if you're careful about how you use it -- to help you build your credit score.