Unsecured personal loans are used every day, and yet many of us don't see them as a form of financing. Overdraft protection, signature loans, tuition financing and credit cards are all examples of unsecured debt. More ominously, payday loans and check advances are another form of unsecured debt, a notoriously expensive form of financing.
The amount of unsecured debt in the US is enormous: for instance, the Federal Reserve Bank of New York says that last summer credit card debt amounted to $670 billion while student loans totaled $1.12 trillion.
Unsecured Personal Loans in Many Guises
In basic terms, unsecured personal debt works like this: you go to a loan source and sign up. The rate and fees you pay depend on your credit rating and the type of loan you select.
As an example, if you have a checking account, debit card or ATM access, you want to avoid the stiff return-check fees that can arise if an account is overdrawn by just a few dollars. According to the Consumer Financial Protection Bureau (CFPB), "If a consumer borrowed $24 for three days and paid the median overdraft fee of $34, such a loan would carry a 17,000 percent annual percentage rate (APR)."
Checking account overdrafts and related debit card and ATM charges can usually be avoided with the use of overdraft protection plans. You pay a small annual fee for a line of credit that's automatically tapped when withdrawals from a checking account or related financial product exceed the account balance. Such short-term loans incur modest interest costs and are meant to be quickly repaid -- in other words, a very cheap alternative to the penalties incurred by an occasional financial lapse.
Lenders also provide "signature" or "personal" loans with no collateral. Because there is no property for the lender to take if you default, these loans are mainly backed by your character (evidenced by your credit rating) and your capacity (your income, which the lender will verify).
You have to complete an application for these loans; your credit report will be pulled and your income will be verified. Typical loan terms range from one to five years, and loan amounts usually range from $1,000 to $35,000.
Interest rates vary according to your credit rating and the lender's policies, but most fall between six and about 36 percent. As always, it pays to get several quotes from competing lenders, so you know if the deals offered to you are fair.
If you see advertising for "personal loans with no credit check" or "personal loans for bad credit," you're probably being sold a payday loan instead.
Payday loans are a form of short-term financing which often involves soaring interest levels and massive fees. According to the Pew Charitable Trusts, some short-term Internet loans come with 650-percent annual interest rates.
For some borrowers, payday loans may seem attractive, because late or missed payments are generally not reported to credit reporting agencies. Such practices, however, hide two issues:
- First, if you do make full and timely payments they're also unlikely to show up on credit reports, meaning you're not getting the credit benefit of good payment practices.
- Second, if a payday loan is disputed and the matter goes to court your credit will be impacted if you lose because there's now a judgment against you and that will show up on credit reports.
Unsecured personal loans, like all forms of financing, can be useful and valuable if used properly and obtained with sensible terms and conditions. Unfortunately, some forms of unsecured financing can lead to a spiral of high interest rates, soaring fees and damaged credit. Be careful when looking at unsecured credit, shop around, and avoid any form of credit where the terms and conditions are unclear, costly or too good to be true.