Credit, in theory, is a relatively win-win situation.
You don’t have the funds to fork over for a certain expense, so a lender gives you that cash – so long as you agree to pay it back, plus a bit more. Although the latter requirement can be a bit of an annoyance at times, the truth is, being lent money when you need it most can be a sweet lifesaver.
Problem is, that credit reliance has become somewhat of an unfortunate addiction for many Americans. According to a recent report by credit bureau TransUnion, credit card delinquencies – arguably the most common kind of credit – were on the rise this quarter.
The report went on to state that average credit card debt per borrower was on the incline, rising from $4,996 per borrower from $4,762 in 2011’s third quarter reports. This finding comes paralleled with the recent studies revealing that the average American owns three separate pieces of plastic in their name.
It’s clear that many consumers have grown accustomed to a credit dependency, intended or not. However, it’s also apparent that most Americans may be biting off a bit more than they can chew when it comes to financing. And more often than not, they might benefit from a finite financial line and a set amount borrowed, rather than a seemingly limitless line of credit.
Unsecured personal loans, while bearing many similar traits to their plastic cousins, come with distinct terms and costs. But while these kinds of loans might be a viable alternative to a costly credit card addiction, they certainly don’t come complication-free.
What’s an Unsecured Personal Loan, Anyway?
Financial loans tend to come in two distinct flavors.
The first, a secured personal loan, relies on some kind of collateral to account for the risk of lending out cash. Essentially, this means a borrower would offer the title to a sizable asset to a lender, like a house or car, in the event of a default.
These are the least-risky kinds of loans for lenders. Although a borrower could default at any time, they’ll at very least have ownership of a sizable asset for selling in the worst case.
The second kind is an unsecured personal loan.
“Unsecured personal loans are defined as fixed-interest rate personal loans that require no collateral or security,” explained Adrian Nazari, founder and CEO of Credit Sesame. “These loans require less paperwork than other types of loans, and the balance of the loan is evenly distributed across a fixed number of payments.”
While they’re not near as common as credit cards for financing, as credit cards currently account for more than $2.5 trillion in transactions every year, unsecured personal loans remain popular with many consumers. According to the National Credit Union Association, Americans spent an estimated $25.58 billion last year on unsecured personal loans.
Although unsecured personal loans contain a certain amount of intricacies and variables, there’s one trait that tends to stand out in consumer’s eyes.
“One of the biggest advantages of getting a loan with no collateral attached is that if you default on the loan there is nothing the creditor can come after you for or collect, such as a car or home,” explained Leslie Tayne, a financial attorney and debt management/resolution specialist in New York.
In the event that a consumer defaults on his or her loan, there is, quite literally, nothing palpable that can be taken from them. And for a great deal of vehicle- or car-owning consumers that aren’t entirely willing to sign over the deeds to their assets, this financial security can be incredibly comforting.
One of the most crucial components for consumers to weigh with their unsecured personal loans, however, is the tremendous risk that lenders are taking when they embark on a relationship with the borrower.
“Because these loans do not require collateral, they are riskier for lenders,” explained Nazari. “Therefore, these loans often have higher interest rates than secured loans.”
But, as Nazari went on to stress, those rates might still edge out similar forms of financing. “[Unsecured loans] are still pretty competitive with credit card rates.”
That’s not to say that unsecured personal loans come cheap. According to the Federal Reserve, the average 24-month unsecured personal loan last year was 10.52 percent, compared to 12.36 percent for a credit card. And according to Nazari, while those rates can sometimes flirt with the seven percent range, it all depends on the consumer’s creditworthiness when applying.
Although borrowers might be out of the water when it comes to losing an asset in a default, they can’t exactly make a clean break from a lender or bank should they fail to make payments. “Although there is literally nothing that can be ‘taken’ from you, there’s always the risk of getting sued by the creditor in the event that you default,” explained Tayne.
Questions to Ask Yourself Before Signing On
Before opting for either a secured or unsecured personal loans, borrowers will need to embark on a bit of introspect and financial assessment.
“Before taking out a loan, people should be asking themselves what their ultimate objective is for borrowing money,” explained Roger Cruise, executive vice president for Credit Vault Publishing. “You should be asking yourself: What is the maximum amount of money I can afford to borrow and pay-off within two to three years? Any longer than this time frame should make you pause as to whether your purchase is really a necessity.”
When considering an unsecured personal loan, consumers should always consider the gravity the loan holds. While you may not be offering your car or home to the chopping block, there are still a number of sticky situations borrowers can become entrapped in should they forgo or flub on payments.
“Understanding your budget is key in terms of knowing what you can afford to pay, and for how long,” added Tayne. “Simply going in for a loan blindly and backing into a loan payment is not financially smart.”