Unsecured loans are loans that are approved without the need for collateral. Lenders take a huge risk when offering these types of loans as they have nothing to fall back to once the borrower defaults in payment. A simple example of an unsecured loan is a purchase made with a credit card.
Importance of Collateral
Most lenders tend to avoid giving credit to individuals with low credit rating. This is because there is a high risk of the creditor defaulting in payment which could cause the lender to incur huge losses! To try and reduce this risk, borrowers provide collateral to serve as a guarantee that the loan will be paid back.
Collateral is an item or property whose value is equal to or higher than the borrowed amount. This item serves as a guarantee that a borrower will pay back the amount borrowed plus interest in the future.
In most cases, if the borrower fails to pay back the borrowed amount within the agreed time period, the lender has the right to sell the item held as collateral. Common assets which are used as collateral include cars, mortgages, title deeds, bond certificates or even family jewelry.
There are numerous risk loving lenders in the market today who are willing to give loans without collateral. This however comes with certain conditions and requirements such as high interest rates and the provision of guarantors. The various types of unsecured loans offered today can be grouped into two major categories:
Types of Unsecured Loans
The most common type of unsecured loan is the short term or payday loan. This loan is common among banks and other major financial institutions and is usually given to people who have a high credit rating. Payday loans have a short period of repayment, sometimes just 14 days, and have a very high interest rate, mostly 30%.
Payday loans are mostly taken by individuals and businesses which have a regular flow of income and repayment is taken directly from deposits. An example of this type of loan is a bank overdraft.
Unsecured loans with a long period of repayment can also be found. These loans are common among small lenders who can be found online. There are two types of alternative online lenders:
Subprime lenders operate online and are more likely to approve an unsecured loan. Their interest rates are generally low and affordable. The reason they are able to lend unsecured amounts at low interest rates is because the repayment period is long say 25 years so the borrower pays small amounts for a large period of time.
Private online lenders are similar to subprime lenders, but their loan amounts are smaller, ranging from $100 to $20000. Due to the small amounts, the repayment period is usually smaller than that of subprime lenders.
So, how do lenders ensure that creditors pay their unsecured loans?
Even though lending money to individuals with bad credit rating is a risky move, lenders can minimize the risk of default if they take the right approach.
Most creditors with bad credit rating are willing to repay their loans to improve their credit rating.
By reducing the interest rates, lenders minimize the risk of default by lowering the creditor’s burden of payment. However, lenders have to ensure that they make profits from this so they increase the period of repayment. This ensures that creditors pay approved unsecured loans fully.