The defining characteristic of unsecured loans is that if you are late making payments or unable to repay your loan, creditors don’t have the right to repossess or claim a particular item of property. Another benefit is that if you face serious financial problems, declaring bankruptcy can usually wipe out most types of unsecured loans. The catch is that because unsecured loans present a higher risk to lenders, they are usually for smaller amounts, have higher interest rates, and shorter repayment periods.
Most types of unsecured loans can be used to buy just about anything. You can use them to pay off existing debt, treat yourself to the vacation of a lifetime, or splurge on a spectacular anniversary gift. However, some unsecured loans, such as medical debt, and student loans are provided for a specific purpose.
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Although there are many types of unsecured loans, it’s useful to divide them into two categories: open-end and closed-end loans.
Open-End Unsecured Loans
Open-end loans, also known as revolving credit, are pre-approved loans you can use repeatedly up to an agreed credit limit. Credit cards are a classic example of open-end unsecured loans. As long as you stay within your credit limit and make the minimum payments set by the credit card company, you can borrow – and pay back – as much as you want.
Open-end loans allow borrowers to have more control over when and how much they borrow. Generally, lenders only charge interest on the portion of the line of credit they use, which can translate into significant interest savings for borrowers.
The dark side of open-end loans is that it is extremely easy to rack up debt and incur huge interest payments, particularly if you only make the minimum monthly payments due.
Closed-End Unsecured Loans
Close-end loans, which are also known as non-revolving credit, provide the borrower with a lump sum of money, which in addition to interest and fees, must be repaid by a certain date. Depending on the type of closed-end loan, borrowers may need to make periodic payments or a single payment at the end of the loan term.
Small banks loans, payday loans and student loans are typical examples of closed-end unsecured loans. Closed-end loans don’t provide the flexibility of open-end loans, but they have the advantage of having a fixed payment schedule which limits the interest borrowers will ultimately have to pay.
Types of Unsecured Loans
Let’s take a look at the types of unsecured personal loans available.
Personal Unsecured Loans
Personal unsecured loans are closed-end loans provided by a lending institution, such as a bank or credit union, which can be used for a wide variety of purposes. The loan terms are set by the lender and generally depend on your credit history and income. All things being equal, the higher your credit score, the lower your interest rate.
Although personal loans are certainly not the easiest or fastest loans to obtain, they do offer one of the lowest interest rates of all unsecured loans. They also have the advantage of having a set beginning and end, which allows you to estimate your monthly payments and overall loan cost. Therefore, personal loans are usually the best option for planned expenses and for borrowers with good credit.
Credit cards are the most flexible unsecured loans around. They are easy to apply for and almost every store and service provider accepts them as a method of payment. Interest only starts accruing on the unpaid balance of your monthly statement. That means that as long as you pay each statement in full, you can use them as interest-free short-term loans, and if your credit card has a rewards program, you can receive cashback and points just for using them to pay for the stuff you would have bought anyway.
The problem is that some credit cards have high interest rates, generally ranging between 16% and 30%, and many consumers don’t pay off their balance within the interest-free grace period. As of February 2014, American households had a total credit card debt of $854.2 billion, an average debt of $15,191 per household.
Some credit card companies offer new customers, usually those with a good to excellent credit history, a 0% interest period which usually lasts anywhere from a couple of months up to a full year. During that period consumers can make purchases and repay them without incurring interest, or can even transfer balances from other high-interest credit cards and enjoy the benefits of paying them off without accruing additional interest. If used wisely, these types of credit cards can provide you with interest-free loans.
Check cards are a special type of credit card that share characteristics of both closed-end and open-end loans. You can borrow as much as you want up to your credit limit within a payment period, but the entire balance must be paid in full when a statement is issued.
Student loans are a type of personal loan offered by the federal government or from private sources, such as a bank or a financial institution, to pay for the educational and living expenses of students attending a college or university. Which expenses are included will depend on the type of student loan. Some you can use to pay for practically any living expense, while other loans are exclusively for tuition expenses and are transferred directly to the educational institution.
After mortgage debt, student loans are the largest source of debt for Americans. As of 2014, Americans owed $1,115.3 billion in student loans. Among those who have a student loan, the average loan balance was $33,607.
As with personal loans, the interest rate of student loans will depend on your credit history. A big advantage of student loans is that payments are generally deferred until after graduation. Something to consider however, is that student debt is not as easy to discharge or wipe out with a Chapter 13 or Chapter 7 bankruptcy as other kinds of unsecured loans. Unless you can prove that even a minimum monthly payment would be an undue hardship, courts won’t discharge student loans. Another drawback of federal student loans is that the government can take special measures, such as garnishing your income tax rebate, to collect late payments.
Payday loans are small, short-term cash advances on a person’s paycheck. Instead of relying on a person’s credit history, payday lenders base their decision to grant a loan on whether the borrower has a job.
It’s easy to get approved for a payday loan. If you have a job and a checking account, you qualify for a payday loan. According to a report by the Pew Charitable Trusts, around 12 million Americans use payday loans every year to get through financial emergencies.
The problem with payday loans is that unlike other types of loans, such as credit card debt, student loans and auto loans, you don’t get to pay them back over time. Once the loan term is over, which is generally just two weeks, you have to pay it back, all at once. Another drawback of payday loans is that they’re expensive. For every $100 you borrow, you must pay $10 to $20 in fees.
The average amount borrowed on a payday loan is $375, which would cost around $55 to get. Many borrowers can’t afford to pay off the initial loan once the two weeks are over and are forced to borrow another $375 to pay the initial loan. The typical payday borrower does this five times and pays an average of $520 in regular and late fees on top of the initial $375 loan, which is the equivalent of a 386% APR.
Most payday loans are sold in storefronts or online but you can also find them in some banks, although they market them as direct-deposit advances.
Peer-to-Peer loans allow borrowers to cut out traditional financial institutions and deal directly with lenders through an online platform. Cutting the middleman allows borrowers with fair to excellent credit to get good deals on personal loans, while investors can get much better interest rates on their savings than they would if there were wasting away in a savings account.
Although peer-to-peer loans, also known as P2P loans, are typically worth $25,000 or less, collectively they amount to billions of dollars in outstanding debt across America. P2P loans are marketed in three main categories: personal loans, business loans and student loans.
When patients can’t afford to pay their medical bills, medical facilities set up unsecured loans so patients can pay their medical debt in installments. Loans for medical expenses are the number one cause for bankruptcies in the United States. In 2013, 1.7 million people filed bankruptcy due to medical debt, which outranked bankruptcies due to credit card debt and home mortgages.
The problem with loans for medical expenses is that they are unexpected and extremely expensive. According to U.S. Centers for Medicare and Medicaid Services, the average cost of a 3-day hospital stay is $30,000 and just fixing a broken leg can cost you up to $7,500. To make matters worse, interest rates are usually very high.
According to the Federal Reserve, over 50% of collection records and 20% of lawsuits on credit reports are due to medical loans. It’s not only uninsured families who are at risk either.
The only upside of medical unsecured loans is that they can usually be included in a bankruptcy filing, but since this will still destroy your credit rating, it’s smarter to use non-bankruptcy options if at all possible. For instance, you could apply for financial assistance to reduce your bill, negotiate a payment plan you can afford, or try to negotiate a discount with the medical provider.
These are only a few of the many types of unsecured loans available to borrowers. Determining which type of loan is best for you will depend on your unique situation. Some factors to consider are what you need the money for, your income level, current living expenses, and your risk tolerance.
Before you sign up for any type of unsecured loan, make sure you completely understand the terms of the agreement and that you can afford to make the payments. Although lenders cannot repossess your home or car, they can still sue you for the balance of the loan, plus penalty fees and legal costs. They can also report you to the credit bureaus, which will seriously damage your credit rating and ability to get another loan in the future.