The Pros and Cons of Unsecured Personal Loans
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UPDATED: Sep 25, 2012
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Personal loans can be used for a myriad of purchases, such as car payments, bills, or even to start a business. There are two types of personal loans; secured and unsecured. A secured personal loan is a loan that is secured by some kind of collateral, usually a home. In the event that a borrower defaults on the loan, the collateral is repossessed by the lender in order to cover the cost of the lost loan. An unsecured personal loan on the other hand has no such collateral.
Since most borrowers understandably do not wish to offer up collateral, they instead apply for unsecured personal loans. Before applying, borrowers should examine unsecured personal financing more closely and determine whether they are comfortable with the advantages and risks.
Unsecured personal loans carry a number of benefits that borrowers can enjoy, especially when compared to other types of credit, financing and loans. The advantages include:
- No risk of repossession
Since no collateral is offered as part of the lending process, there is no risk of it being repossessed in the event of a default.
- The custom interest rates
Each applicant’s financial history, credit score and debt-to-income ratio influences the interest rate tied to their loan.
- No variable interest rate
Unlike credit cards, unsecured personal loans don’t lead to ballooning monthly payments or skyrocketing interest rates. This is because unsecured personal financing lacks the high and variable interest rates that come with most credit cards. Credit cards on the other hand are highly ubiquitous and most lenders, like banks, offer them with “one size fits all” interest rates for each type of credit card they offer.
Unsecured personal loans are more affordable when their secured counterparts. Cash advance loans, for instance, often have annual percentage rates (APR) in excess of 200 percent. These high interest rates can leave borrowers vulnerable to getting trapped in a cycle of debt by forcing them to take out more money to pay off previous cash advance balances. This is called a “rollover” and is a fairly common experience for payday loan borrowers. In contrast to this, unsecured personal lenders will almost never offer a second unsecured personal loan to a borrower that has defaulted.
These excellent advantages may be just what some prospective borrowers are looking for in a loan. While the advantages of unsecured personal financing may cause some prospective borrowers to apply immediately it is better to be cautious and review the risks first.
All financing carries with it risk. While most borrowers do repay their loans, various factors such as a job loss or unexpected expenses can severely limit one’s ability to repay. Before taking out any type of loan, it is important to review the risks that borrowing leaves a consumer vulnerable to. Here are some of the risks associated with unsecured borrowing:
- High interest rates
Since unsecured personal financing lack the security of collateral, they often come with higher-than-expected interest rates. These high interest rates can accrue and prove difficult for borrowers to pay off if they suffer any financial hardship throughout the lifetime of their loan. While some lenders may be willing to adjust monthly payments if a borrower is facing financial difficulty, not all lenders are so merciful.
Like many other types of financing, defaulting on an unsecured personal loan can carry massive repercussions. Debt collectors may pursue defaulted borrowers, while punitive fees may be piled on outstanding balances. In some cases, defaulting may even lead to wage garnishments as lenders seek to recover their lost money.
These advantages and risks can help aid borrowers in deciding whether or not to apply for an unsecured personal loan. By being informed, borrowers are better able to manage their vulnerability to risk prior to borrowing a loan. Unsecured personal financing can be an excellent way for borrowers to obtain needed funds but knowing the advantages and risks is a necessary first step.