Risks of Unsecured Personal Loans
Kevin is a former fintech coach and financial services professional. When not on the golf course, he can be found traveling with his wife or spending time with their eight wonderful grandchildren and two cats.Read full bio
At a Glance
Borrowing money always comes with some risk. There’s the obvious challenge of being able to pay it back on time. Interest rates and fees need to be accounted for. The monthly payment needs to fit into your monthly budget. If you’re accepting a secured loan, you’re at risk of losing your collateral if you default. Unsecured loans don’t require collateral, but there is still risk involved with them. In this article, we’ll break down what that risk is.
What is an unsecured personal loan
It’s important to go into any financial arrangement with knowledge and understanding of what you’re getting into. Unsecured loans are personal installment loans where the lender does not require security, also known as collateral, to secure the loan. Examples of collateral include a vehicle or equity on your home. Car loans and mortgages are secured loans.
With an unsecured loan, the lender determines loan eligibility by evaluating the applicant’s credit score and credit history. Using that information, they either approve or deny the application and then set the payment terms and conditions. Applicants with higher scores and a better credit history will get lower interest rates and more favorable payment terms.
These loans are called installment loans because the borrower agrees to pay the money back in equal monthly installment payments. The interest rate is typically fixed, so the amount of each monthly installment payment won’t change, making it easier to budget. With a variable rate, the payment amount would change each month.
How to get an unsecured loan
Getting an unsecured loan is not difficult unless your credit score is extremely low. Unsecured loans are offered by traditional banks, credit unions, and online lenders. Most lenders these days have an online application process, so you can do this from the comfort of your own home. You’ll need the following pieces of information to apply:
- Phone number
- Email address
- Valid Driver’s license or State ID
- Proof of Income
You don’t need to know your credit score because the lender will look it up, but it’s not a bad idea to check it on your own before submitting a loan application. You can also view your credit report by going to FreeCreditReport.com, which is a service offered by Experian. The lender may ask you questions about the report, so it’s good to have a copy on hand.
Related: Secured vs. Unsecured Personal Loans
9 possible risks associated with unsecured personal loans
This is where we get into the risk component of unsecured personal loans. As we stated earlier, you’re not putting up collateral, so there’s no risk of losing your personal possessions or property. That said, there are still risks. Be aware of the following:
1. Interest rate
Loan applicants should always compare different loan offers because interest rates vary from lender to lender. Watch out for high interest rates and variable rates that could cause your monthly payment to increase or decrease, making it more difficult to budget.
2. Penalties on early pay-off
Paying a loan off early usually means you can save money by eliminating extra income payments. Those savings may be offset if the lender charges an early-payoff penalty. Check your loan contract before signing to make sure that’s not one of the conditions.
3. Big upfront fees
Familiarize yourself with the term “origination fee.” This is a fee that the lender charges the borrower upfront when you apply for the loan. It may be embedded in the overall cost of the loan, so read the fine print carefully. Origination fees could be several hundred dollars.
4. Privacy concerns with online lenders
It’s generally safe to borrow money from an online lender, but you need to be careful about who they share your information with. One trap that online borrowers often fall into is checking boxes for “updates” or “marketing.” Those may infringe on your privacy.
5. Precomputed interest on an early payoff
Precomputed interest is different from simple interest because the entire amount of total interest on the loan is calculated ahead of time and added to the amount you’re borrowing. This affects you if you try to pay the loan off early because you won’t save any money on the interest. It’s considered part of the loan balance, so it’s due regardless of when you pay.
6. Unnecessary loan Insurance
Legitimate lenders in the U.S. are insured by the Federal Deposit Insurance Corporation (FDIC). You’re protected under the Truth in Lending Act (TILA). Read up on both before signing up for any unnecessary “loan insurance.”
7. Payday loans
Payday loans can look like regular personal installment loans until you get to the contract and realize your interest rate is as high as 400% and your payment is due in thirty days. This is the most expensive way to borrow money. Seek another alternative if you can.
8. Unnecessary complications
Complications with unsecured personal loans could be as simple as not recording the payment date or as complex as your rates adjusting mid-term. Understand what you’re protected against and read the terms and conditions carefully to avoid these situations.
9. Impact on credit score
The impact on your credit score is a risk with any type of loan: secured or unsecured. The risk is twofold. There will be a slight dip when you first take the loan out due to the “hard inquiry” the lender makes. You’ll also see a drop if you miss payments, so pay on time.
Tips to minimize the risks while taking out an unsecured personal loan
The best way to minimize risk with unsecured personal loans is to read the terms and conditions carefully before signing the agreement. You should also make sure you’re on a secure computer when doing your loan application. Internet cafes or libraries with public Wi-Fi are not recommended. Finally, shop around for better terms if you’re not satisfied. That can help you minimize the risk of high fees and interest rates.
Yes. Unsecured loans are generally safe. Do business with a reputable lender and only use a secure computer and internet connection if you’re applying online.
Personal loans can be either secured or unsecured. With a secured loan you’ll be required to put up collateral that could be a vehicle, home, or other material possessions.
A default on a personal loan will have a negative impact on your credit score and could subject you to collection calls or even legal action.