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What are Unsecured Personal Loans?

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When you need some extra cash - perhaps for a vacation, home improvement, or personal expense - you may consider taking out a loan. You can do this in many different ways: you can use your credit card to get a cash advance, take out a payday loan, or get a second mortgage on your house. You can also take out an unsecured personal loan.

What is an unsecured personal loan? It's a loan for which you are not required to put up collateral, such as your house or car. Credit cards are a type of unsecured loan because if you fail to pay, the credit card company has no authority to take your house or car. Your home mortgage is a secured loan because if you fail to make payments, the holder of the loan - the bank or mortgage company - can seize your house.

You may think that an unsecured loan is by definition much better than a secured loan because the risk to you is less, and the risk to the loan issuer is greater. But the creditor will make you pay for the increased risk they are carrying by charging you a higher interest rate than if you were taking out a secured loan.

Taking out an Unsecured Personal Loan

Say you need $10,000 quickly, and let's assume you have an excellent credit history. You go online to the website of a reputable national bank. You'll find a handy personal loan rate calculator and you can see how much you'll be paying.

You enter how much you need ($10,000). You enter your state (a bank's ability to lend and the fees it charges may vary from state to state), and the term (let's say you think you can repay it in two years, or 24 months). The website says that your annual percentage rate (APR) will be 12.36% and your monthly payments will be $472.42.

You can see immediately that a rate of 12.36% is much higher than a typical mortgage loan of 5-6%. This is because the loan is unsecured - if you default the bank has little recourse other than turn your debt over to a collections company. The rate of 12.36% is for a customer with an excellent credit score; if you have poor credit your rate will be much higher or you will be turned down.

If you pay $472.42 per month, by the time you have paid off your loan in 24 months you will have paid a total of $11,338.08, not including fees. This is something that you need to consider carefully; in two years you will pay over thirteen hundred dollars extra because you borrowed ten thousand.

What are the pitfalls?

  • Do not respond to unsolicited phone calls, emails, and/or letters offering you a "guaranteed approval loan".
  • No reputable loan company or bank will ask you for a fee in advance to cover the cost of the application, processing, loan insurance, or the first month's premium. If you're in doubt, contact your local Better Business Bureau.
  • Once a scammer has convinced you to pay an up-front fee, invariably the scammer will ask for additional fees. If you try to complain or ask to speak to a manager, you will be directed to voicemail and your calls will not be returned.
  • Never wire money via Western Union or send a Moneygram to any lender, and especially to anywhere outside the U.S. such as Nigeria or even Canada.

Before you decide to take out an unsecured personal loan, be sure you really need the money. If possible, it's better to solve your cash flow problems without taking additional debt. But if you decide to consult with a lender, be a smart shopper, and get the best deal you can.