An unsecured loan is a personal loan that is not guaranteed or “secured” by something like a house, car or business. Because secured loans are secured by an asset, this makes them safer for the lender. If you don’t pay your secured car loan, the bank just repossesses your car, this gives the lender a safety net. Because this type of loan presents less of a risk to the lender, they are easier to get than an unsecured loan. An unsecured loan is just a personal loan based on your word that you’ll pay the money back, but the lender has limited recourse if you don’t. If you don’t pay, the lender will turn your loan over to a collection agency and depending on the amount of money you default on, the lender could choose to sue you. Even if they win their case, if a debtor is unemployed or has no assets, it makes it hard to collect. This is why banks use higher lending standards when agreeing to give an unsecured loan. For an unsecured loan, your credit score is going to play a big part in whether you get the loan or not, a higher score will be required for the unsecured loan than with other types of loans. An unsecured loan may also be referred to as a personal loan, a signature loan, a payday loan, or an installment loan.
Benefits of the Unsecured Loan
The main benefit of the unsecured loan is that it provides money for whatever you may need. With a secured loan you have no flexibility for how you spend the money, but an unsecured loan can be spent however you want. The bank will ask how you intend to spend the money and they’re going to want a good answer that makes you sound like a good risk, but once they release the money, you can spend it as you see fit. An unsecured loan can be used for a new transmission, fixing your home’s air conditioning, or any other unexpected emergency that may crop up.
In the case of payday loans, small amounts of money can be obtained fairly quickly with little hassle making them a good choice for emergencies. See below for a more complete discussion on the potential downside to payday loans.
Downside to the Unsecured Loan
The two main downsides to the unsecured loan are they can be hard to get with bad credit and in some cases they can be very expensive if not obtained from a traditional lender like a bank or credit union. If you get a secured loan from a bank or credit union then the rates are reasonable, but if you deal with a payday lender or check cashing lender, then the rates can be astronomically high, perhaps even over 300% interest per year.
Payday Loans or Cash Advances
This is a controversial type of unsecured loan that is offered at small loan shops and check cashing storefronts, rather than banks. To get a payday loan you give the lender a postdated check that they will cash at a later date while they loan you the money. These loans are short term loans for usually only a couple hundred dollars.
Benefits of Payday Loans
The only benefit of this type of loan is quick easy cash. Plus you don’t need great credit so I suppose that makes two benefits, but the downside of these loans is BIG.
Downside of Payday Loans
These loans are considered by some people to be just steps away from legalized loan sharking. In fact, these states have even outlawed payday loans:
- Connecticut
- Georgia
- Maine
- Maryland
- Massachusetts
- New Hampshire
- New Jersey
- New York
- North Carolina
- Ohio
- Oregon
- Pennsylvania
- Vermont
- West Virginia
The main reason that these states have outlawed the practice of payday loans is due to exorbitant interest rates they charge. There are usury laws in some states that prevent unreasonably high interest rates, but payday lenders got around these laws by partnering with banks in states without usury laws. This effectively allowed them to sidestep the law because lenders fall under the law of the state where the bank is located not the payday lender. In 2005, the FDIC limited how payday loans were administered. Lenders used to be able to roll over loans indefinitely, ensnaring unsophisticated or desperate people into interest rates that were over 300% per year making it almost impossible for low income people to get out of debt. The new FDIC rules states that after a loan was rolled over 6 times, it would then have to convert to a traditional long term loan with manageable interest rates. Due to these changes, banks have been out of the payday loan business since 2007.
Summary
An unsecured loan is can be great for emergencies, but they shouldn’t be used frivolously. Don’t use an unsecured loan for a vacation, furniture, or other items that you should be buying with cash, remember you are paying interest on this loan and interest can begin to add up, this adds to the overall price of what you are buying. For some people, the cycle of payday loans can be next to impossible to break out of, so this type of unsecured loan is almost never a good idea.
