An unsecured loan is a loan that is not backed by collateral. Also known as
a signature loan or personal loan. Unsecured loans are based solely upon the
borrower's credit rating. As a result, they are often much more difficult
to get than a secured loan, which also factors in the borrower's income.
An unsecured loan is considered much cheaper and carries less risk to the borrower.
However, when an unsecured loan is granted, it does not necessarily have to
be based on a credit score. For example, if your friend lends you money without
any collateral, meaning something of worth that can be repossessed if the loan isn't
repaid, then your credit score has zero to do with it, but rather the value of your
friendship is at stake.
Therefore the real meaning of an unsecured loan is that it is not backed by any
object of value and is lent to you based on your good name. For financial
institutional purposes, they may want to look at your credit score because they
are not your friend and it is strictly a business transaction, therefore your good
name may be associated with your historical payment history on prior debt, reflecting
in your credit score.
Types of unsecured loans
There are three types of unsecured loans.
* First there is a personal unsecured loan, meaning a loan that you individually
are responsible for the repayment of.
* Second is an unsecured business loan which leaves the business responsible for
the repayment.
* Finally there is an unsecured business loan with a personal guarantee. With
the latter, although the borrower is the business, you as an individual will be
the payer of last resort if the business defaults on the loan.
Lending decision criteria
Since unsecured loans are not secured against property or any asset, it is more
difficult for a lender to get their money back if the borrower does not or cannot
repay the loan. Because of this increased 'risk' (compared to secured loans)
unsecured lenders tend to have stricter underwriting rules. In particular,
lenders will look at the potential borrower's credit history and how they have conducted
their previous and current credit or loan accounts.
In summary the lender has to decide, based on their borrower's credit history, how
likely are they to repay the loan. If the risk is too high, the borrower will
be declined for the loan. If the risk is acceptable, then the lender will
(subject to other minimum requirements) make a loan offer.
Rate determination
Assuming a loan offer is made, the actual APR will normally depend on two things,
the loan amount and that level of risk. Generally speaking, the higher the
loan amount the lower the APR will be. In terms of the level of risk, the
higher the risk the higher the APR lenders will charge - this is known in the loan
industry as rate-for-risk.