When you decide to take up an unsecured loan, it simply means you won’t have to offer any collateral for it. This is why the lenders rely on your creditworthiness as their source of assurance that you can and will repay the loan in time. Unsecured loans are common today with many more people opting for them. Examples are students and personal loans.
With these two types of loans, there is no collateral requirements from the lender to secure the loan. All you have to do is agree to the terms set by the lender and the payment plan. There is an interest charged on the amount lent that you have to keep in mind and the duration it takes to clear the loan. Learn more about Advantages vs Disadvantages of a Personal Loan.
The truth is, these are high-risk loans because the only assurance the lender has is your word of mouth to pay the loan back. This is why a thorough check on your creditworthiness has to be conducted by the lender to clarify your capability to meet the terms of the loan and at the right time. Your credit score should be high otherwise you won’t qualify. Unsecured loans take longer to be approved and come with interest rates that are much higher than those of secured loans. Unsecured loans are not favorable, even their terms don’t have your best interest.
Negative Effects of Unsecured Loans
There is a reason unsecured loans are not as popular and take time to process. Yes, you can take the personal loan and use it as you see fit but there are some things to consider before you sign those papers.
a) Unfavorable Terms
Unsecured loans require no collateral which means they carry a higher risk of non-payment. The lender needs to create a strategy to ensure you’ll pay back the loan on the terms set. The Terms and Conditions of an unsecured loan are to protect the lender from non-payment which means you might find yourself in a fix later on. Read through the T&C before signing for an unsecured loan to see if you can live with what the lender expects from you.
b) Debt Cycle
You may be tempted to take a personal loan to clear another loan. This means you get trapped in a vicious cycle where you take a loan to pay another and so on. With every new loan you get, the amount borrowed goes higher and higher and so does the interest rate charged. Within a short time, you find yourself deep in a debt hole with a huge amount to repay.
Credit cards are another trap that lures many people into financial debt. Taking a loan to clear a credit card bill then using that card to buy more stuff on credit is a vicious cycle.
c) Extra Fees
Unsecured loans are not as cheap as they seem. Even though they’re advertised as easy and quick money, there are many underlying factors that the lenders only disclose to you later on. Extra charges are dropped on you once your loan goes through in the form of origination fees.
This is a percentage charged on the amount you borrowed that the lender uses as the processing fee. You might have to pay from 1% to 6% of the loan borrowed back to the lender as a processing fee. The lender either adds this amount to the total loan to pay back or deducts it from the amount you borrowed. Your creditworthiness is affected by getting more in debt.
d) High-Interest Rates
The lenders protect themselves by charging borrowers high interest rates. This means you have to pay back more amount than what you borrowed. The truth is, this is not illegal. You provide no collateral for the lender to use as security on the borrowed amount.
This is why many lenders have obscene interest rates on personal loans. The high-interest rates can prove brutal to your finances because they make your monthly payments high which dents your monthly budget. This can lead to more credit card debt with many more financial matters being paid off on credit. Keep in mind, it may impact credit score.
e) Penalties to Paying off the Loan
There is a pre-determined timeline which you have to accept from the lender on how long it’ll take you to pay off the loan. You might be tempted to pay it off once when you get some lump sum. But this might not be the right move. Some lenders put a condition in the T&C that early payoff is penalized. This is why it’s important to inquire about such matters before taking a loan from any lender. The penalty charged on early repayment of the whole loan can plunge you back into more debt.
f) Loan Insurance
Lenders have now come up with additional insurance charged on the borrowed amount to secure it. This is because you offer no collateral when borrowing the loan and so might not be inclined to refuse the insurance pitched to you. Getting insurance on the loan seems like a good idea but it also means more money to repay. This only plunges you further in to debt especially if the loan is to repay another loan or credit cards. Learn more about what happens if you can’t repay a loan.
Unsecured loans seem cheap and easy to get. Though the process to secure a large amount takes time and has extra fees charged on it, many people still apply for them daily. These loans can offer temporary reprieve on the debt or situation at hand, but they’re charged high interest rates. They even have additional fees like origination that you must pay once you sign for the loan.
It’s better to take time to think about whether you truly need the loan or not. If you do, then shop for a lender with a good interest rate and favorable terms and conditions. You should have the option to pay off the whole amount once if you can without any penalties. Also, look for a lender that allows you to get outside insurance cover on the loan for added security if necessary. Check out our Best Unsecured Loans reviewed.