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What is an unsecured personal loan and when should you use one?

Photo illustration by Fortune; Original photo by Getty Images

When you have significant financial expenses to cover and don’t want to use a credit card to pay for them, personal loans offer yet another option and can often save you money. Unsecured personal loans typically feature lower interest rates than credit cards and longer repayment timelines.

But before you begin shopping around for an unsecured personal loan, it’s important to understand how they work, including their pros and cons and how to secure the most competitive interest.

What are unsecured personal loans and how do they work?

Personal loans are funds borrowed from a financial institution that are repaid in installments with interest over a specified timeline. The two most common types of loans are secured and unsecured personal loans. The biggest difference between the two is that unsecured personal loans do not require providing collateral in order to obtain funding, while secured loans do.

“They do not require collateral like a home equity loan, margin loan, or 401(k) loan would. Their unsecured nature is similar to a credit card, where lenders assess your ability to repay the loan based on things like your credit score and free cash flow,” explains Brian Walsh, a certified financial planner with SoFi, a personal finance company. “Unlike credit cards, however, personal loans typically come with competitive interest rates and are considered installment loans, which means they have a defined payback period such as three, five, or seven years.”

Because the loan is not secured by collateral however, you will often pay a higher interest rate than on a secured loan. In addition, without collateral to back-up the loan, credit score requirements for applicants may be higher to obtain approval.

Pros and cons unsecured personal loans

Like any financial product, there are both benefits and drawbacks to consider when using an unsecured personal loan.

Pros

  • No collateral required: Chief among the benefits of an unsecured personal loan is the lack of collateral required. This means when borrowing, you’re not putting a house, car or some other valuable asset on the line should you experience unexpected circumstances and be unable to repay the loan.

  • Funds arrive quickly: Once the application is complete and approval has been received, it’s not unusual for funds to be made available in as little as 24 to 48 hours depending on the lender.

  • Low interest rates: There’s often a significant difference in interest rates between personal loans and credit cards—with the rates on loans being far more competitive for those with good credit. “Interest rates on personal loans are almost always lower than those on credit cards, which may run 15% to 25%,” says Barry Rafferty, senior vice president and head of personal loans at Achieve, a digital personal finance company that connects consumers with loans. “The average rates on personal loans are 14% to 18%. But they can vary from 7% to 8% for people with excellent credit.”

Cons

  • May be difficult getting approval: For those whose credit score is less than ideal, obtaining loan approval can be challenging. Your time may be better spent working on improving your credit and applying for a loan at a later date.

  • Higher interest for those with lower credit: Yet another drawback of personal loans for those with lower credit is that the interest rate you’re likely to be offered will be far higher than for other applicants. It may even be higher than what you’re paying on a credit card.

  • Origination fees: Many lenders charge origination fees for establishing a loan and these fees can range from 1% to 5% of the loan amount.

What can personal loans be used for and when should they be used?

The funds from a personal loan can really be used for whatever you need. This could include paying for home renovations, a wedding, significant travel expenses or debt consolidation. But just because you can use personal loans for nearly anything, doesn’t necessarily mean you should, says Walsh, who points out that it’s important to manage your debt levels wisely and avoid spending more than you can reasonably repay.

“Common examples where personal loans can make a ton of sense are debt consolidation, certain home improvements, family planning, or certain major purchases. Generally, if you need a home improvement or major purchase then a personal loan can make sense,” says Walsh. “But if it’s completely optional, then you may want to reflect on the decision a bit.”

For example, using a personal loan to fix a broken furnace or leaky roof can be a wise decision. But using a loan to cover the costs of a flashy new infinity pool in your backyard is something you may want to think twice about.

“For optional items, it may be better to pause a bit and save up money to avoid paying interest when you do not truly need to,” says Walsh.

How get an unsecured personal loans 

If you’re considering a personal loan, here’s how to navigate the process and the typical steps you can expect to go through.

1. Shop around with multiple lenders to find the best offers

The first step in obtaining a personal loan should always be shopping around to ensure you are researching the options and ultimately getting the best rate and overall loan terms for your financial needs. As you’re shopping around, take the time to review such factors as origination fees, repayment timelines, and other variables that may be important such as early repayment penalties and late payment fees.

“There are a lot of lenders out there. It’s important to choose the right one for you,” says Lattman. “You’ll want to look for a lender who is transparent about the terms of their loans, has a track record of happy customers, and has trained loan specialists to help you make informed decisions.”

2. Get pre-qualified 

While shopping around, it’s also possible to get pre-qualified with various lenders, which can give you a better sense of the specific loan terms you may be eligible for.

Obtaining pre-qualification is usually quick and only requires submitting basic personal information such as social security number, address and annual income details. It’s also important to note that getting pre-qualified typically does not impact your credit score as lenders will do what’s known as a soft-credit check. These types of credit checks are conducted for informational purposes rather than an application approval.

3. Submit a formal application

Once you’ve decided on the lender and loan terms that work for you, it’s time to submit a formal application. This step will require providing more personal information about your debt, assets and other details.

“In general,personal loan applications are like any other loan product in that the lender will need personal identifying information, the stated purpose of the loan, and income verification such as a pay stub or equivalent,” says Rafferty.

4. Receive funds

The time between application approval and receiving funds is typically very short. For many online lenders in particular, funds may be deposited into your account in as little as 24 hours. You’ll need to provide the lender with bank routing and account numbers as part of this step.

“This should be a quick and painless process where you can get the money in a day or two by linking your checking account,” says Walsh.

5. Begin making payments

Once the loan proceeds have been dispersed you will begin making monthly repayments with interest. Most loan repayment terms are between 12 months and 60 months. And it’s important to understand that while some loans have no prepayment penalties should you want to eliminate your debt ahead of schedule, others will charge a fee, so be sure you’ve read the loan agreement carefully.

The takeaway

Unsecured personal loans can be an extremely valuable in helping you finance some of life’s significant expenses. The key to making the most of personal loans however, is to shop around and obtain the most favorable interest rate and loan terms possible. And if your credit is less than ideal, bear in mind that a personal loan is not always the right choice, as you may pay a steep interest rate to obtain funds.

This story was originally featured on Fortune.com

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