How does an unsecured line of credit work? What are the risks and benefits associated with it? This article answers that and more. This article tells you about the benefits of getting an unsecured line of credit with examples.
What is an unsecured line of credit?
A line of credit, or loan, is an agreement between a lender and an individual/company that allows the lender to provide money to the borrower. A secured loan is attached to collateral that the lender can seize or sell to recover the loss if the borrower does not return the money in the agreed-upon time frame.
On the other hand, in an unsecured line of credit, the lender does not have any security for the loan. In this case, the lender assumes a more significant risk in granting the loan as none of the borrower’s assets are subject to seizure upon default.
If you don’t have a great credit score or assets to declare as collateral, it’s challenging to get a loan from a bank. However, there exist other options to obtain funds from financial institutions.
One of the most popular alternatives is an unsecured line of credit. An unsecured line of credit authorizes you for a loan up to a certain limit without any collateral.
While this sounds exciting, an unsecured line of credit comes with risks. The biggest one is a failure to repay the loan, being charged a higher rate of interest, and having your credit rating affected.
How does an unsecured line of credit work?
Unsecured loans can be no-collateral installment loans, like a personal or student loan, or an unsecured revolving line of credit, like a credit card.
In most cases, you can apply for an unsecured line of credit online. Once you’ve filled out your paperwork, you can submit your request. The bank will check your credit score to determine how much money they are willing to lend you. Once approved for a certain amount, you can use the credit line as you see fit.
As with a credit card, you will be charged interest on an unsecured line of credit. However, as lenders take more risk than if you had put up collateral, your interest may be higher than what you’d pay on a secured loan.
You can use an unsecured line of credit to bridge a gap in your finances or cover unexpected expenses. While you are not required to put up collateral to receive an unsecured line of credit, you must make full and prompt payments.
Who should opt for an unsecured credit line?
Unsecured loans aren’t for everyone. Many lenders only offer unsecured loans if your credit score is at least 670. Usually, an unsecured loan is approved only for a small amount of money, and you have to pay a high-interest rate compared to secured loans.
Besides, there are risks associated with this form of credit. Your financial situation and the purpose behind procuring the loan can determine whether an unsecured loan is a suitable option for you.
As someone who doesn’t wish to pledge collaterals for loans, it could be smart to consider opting for an unsecured credit line if you:
- Need to cover an unexpected expense or a large purchase
- Have a good credit score
- Have a steady stream of income which means reduced chances of defaulting on repayment of installments.
While these loans are a great way to cover significant expenses quickly, the bank or lender will check if you qualify to be a recipient of an unsecured credit line. To minimize their risks, they will check your credit history and income and calculate your debt to income ratio.
Advantages of an unsecured line of credit
Unsecured loans come with many advantages and can be more quick and convenient than their secured counterparts. Some of the benefits of an unsecured line of credit are-
- No collateral required: One crucial advantage of an unsecured line of credit is that it doesn’t need you to put up collateral.
- Multi-purpose use: Secured loans can usually be used for a fixed purpose, like buying a house or a car. On the other hand, an unsecured loan offers the freedom to spend the money however you see fit. You can use it to cover multiple or a single expense.
- No risk of losing collateral: As a borrower, you undertake less risk as you don’t need to pledge any collateral that can be seized if you default. This reduces the stress on borrowers.
- Quick processing: With unsecured loans, you have faster access to money. An application for a traditional bank loan can take months to approve, whereas unsecured loans involve less paperwork and procedure.
Risks of an unsecured line of credit
While they come with many benefits, there are a few disadvantages to opting for an unsecured line of credit. The risks associated with unsecured loans are:
- Demanding eligibility criteria: In unsecured loans, there is a significant amount of risk on the lender’s part. To compensate for this, lenders give money to borrowers who meet specific eligibility criteria such as excellent credit scores and credit history, proof of steady income, or no other debts. Unfortunately, these are difficult for a number of individuals to meet, making it difficult for them to get an unsecured line of credit.
- Smaller loan amounts: As there is no collateral attached, the loan amounts that lenders are ready to disburse are generally smaller when compared to regular loans.
- Higher interest rates: With higher risks come higher interest rates. Unsecured loans have significantly higher interest rates than regular loans.
- Short-term loans: If your amount is on the higher side, the EMI will likely be high even if you choose the maximum possible tenure.
How to use an unsecured line of credit wisely
Unsecured loans can be a great way to quickly get the money you need. However, they come with risks, and if you decide to take one, you need to use it wisely. It’s often wise to consider the following while using an unsecured line of credit:
- Be aware of the limits: Be prepared to be limited in the amount of debt you can accrue with the credit line. This understanding can help you stay within your means.
- Keep a budget: Credit works better when paired with a tight budget. Be aware of where you’re spending and prioritize your expenses. You can avoid the risks of credit by keeping track of your spending.
- Consolidate loans: You may be eligible for a debt consolidation loan if you have unsecured credit card debt. When you consolidate your unsecured credit card debt with a personal loan, you can save money on interest and consolidate your payments into one monthly payment.
- Don’t pay interest directly: Avoid charging interest directly to the line of credit. Instead, charge only authorized purchases that you’re going to pay off with a monthly payment.
If you decide to go ahead with an unsecured line of credit, you can take some simple steps before and during the loan application:
- Calculate how much you need, then borrow only this amount even if the lender tempts you with larger amounts.
- Find a lender that satisfies all your criteria. Most national and local banks offer unsecured credit lines along with a few online lenders.
- Compare loan offers to find the best combination of loan terms and interest rates most suitable for you.
- Submit an application to your preferred lender.
- Provide any additional documentation required. For example, you might be asked for extra confirmations if you have a poor credit score.
- Accept loan funds and ensure timely repayment to avoid hurting your credit score.
While considering an unsecured loan, it’s important to note that they are supported only by a borrower’s creditworthiness. Therefore, before opting for this option, it’ll be worthwhile to build a strong credit score to ease the process of securing a loan.
Another reliable and convenient way to get unsecured credit is through a Vital Card that offers competitive interest rates, great benefits, and credit rewards.
Sources
Differentiating between secured and unsecured loans | Consumer Finance Protection Bureau
What Is a Secured Loan? | Experian
What Is an Unsecured Personal Loan? | Experian
Vital Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.