Personal loans (also called unsecured loans, character loans or signature loans) require no collateral, and are guaranteed solely by the borrower's promise to repay them. Unsecured personal loans sometimes get a bad rap because some people confuse them with payday loans, title loans, cash advances and other extremely expensive short-term forms of financing. They often come in behind credit cards when people want to borrow without putting up collateral. Yet, true unsecured personal loans are often a better choice. Here are five situations in which a consumer should consider one.
Wants a Lower Interest Rate
According to a January 2015 Federal Reserve report, average rates for credit cards were 13.91 percent, while interest rates for 24 month personal loans averaged 10.22 percent. It may be possible to obtain a better rate with a personal loan than with a credit card. Of course, the rate offered depends in part on the applicant's credit rating and individual lender guidelines -- it makes sense for consumers to compare the credit card and personal loan rates that apply to them. March 2015 data from LendingTree shows how applicants' credit ratings corresponded to the offers they received:
Needs Cash Fast
Because there is no collateral to appraise, unsecured loans can be processed and funded quickly (sometimes within hours). Lenders base their decisions on two primary factors -- the applicant's credit rating, which determines the rate he or she will be offered, and the individual's debt-to-income ratio, which determines how much the lender is willing to lend.
There are unsecured personal loans available for many different credit tiers. Generally, lenders assign credit grades to applicants and then base their rates on those grades.
Prefers a Fixed Rate and Term
Unlike credit cards and other revolving accounts, which come with variable interest rates, personal loans usually carry fixed interest rates that do not change during the loan terms. In addition, personal loans are fully-amortizing, meaning that as long as all payments are made in full and on time, the loan will be paid off at the end of its term. Revolving balances can be difficult to zero out if the borrower isn't a disciplined debt manager. Personal loans are appropriate for those who don't want to continuously carry debt.
Some borrowers prefer to have the structure of regularly set loan payments. They want to make the same payments at the same intervals on a set schedule until the loan is paid off. Personal loans suit borrowers on a fixed income or working within a strict budget who don't want the worry of increasing payments that can accompany interest rate resets on a personal credit line.
Trying to Cut Spending
Personal loans also make sense for spenders who are tempted by access to the easy credit offered by credit cards, which borrowers can tap on demand up to the preset limit. With an unsecured loan, the borrower receives a lump sum and immediately begins repayment. As payments are made, the balance declines, and the consumer cannot run the balance back up again.
Trying to Boost a Credit Score
Personal loans can be a good credit score boosting strategy for those who carry balances on their credit cards. A full 30 percent of the FICO score is driven by "credit utilization," the percentage of available credit being used, and anything over 30 percent utilization causes a score reduction. By paying off credit card debt with a personal loan, which is considered an installment, not revolving, account, the borrower increases the amount of available credit, immediately lowering the utilization ratio. Over time, if the consumer repays the personal loan without increasing credit card balances, scores can continue to rise.
In a nutshell, unsecured personal loans make sense when a borrower needs fast cash without putting up collateral, wants a fixed rate and payment, or is trying to avoid the temptation of the easily available credit that comes with a credit card or credit line. To get the best rate on a personal loan or any other loan, it's important for consumers to shop and compare rates and terms from competing lenders.