Personal Unsecured Loans

A personal loan is a loan that is not backed by collateral. It is also known as a signature loan or unsecured loan.

Personal loans are based solely upon the borrower's credit rating. As a result, they are often much more difficult to get than a secured loan, which also factors in the borrower's income. A personal loan is considered much cheaper and carries less risk to the borrower. However, when a personal loan is granted, it does not necessarily have to be based on a credit score. For example, if your friend lends you money without any collateral, meaning something of worth that can be repossessed if the loan isn't repaid, then your credit score has zero to do with it, but rather the value of your friendship is at stake. Therefore the real meaning of an personal loan is that it is not backed by any object of value and is lent based on your good name.

A financial institution, however, may want to look at your credit score because they are not your friend and it is strictly a business transaction. Therefore your good name may be associated with your historical payment history on prior debt, reflecting in your credit score.

Types of unsecured loans

There are three types of unsecured loans.

First there is a personal unsecured loan, meaning a loan that you individually are responsible for the repayment of.
Second is an unsecured business loan which leaves the business responsible for the repayment.
Finally there is an unsecured business loan with a personal guarantee. With the latter, although the borrower is the business, you as an individual will be the payer of last resort if the business defaults on the loan.

Lending Criteria

Since personal loans are not secured against property or any asset, it is more difficult for a lender to get their money back if the borrower does not or cannot repay the loan.

Because of this increased 'risk' (compared to secured loans) unsecured lenders tend to have stricter underwriting rules. In particular, lenders will look at the potential borrower's credit history and how they have conducted their previous and current credit or loan accounts.

In summary the lender has to decide, based on their borrower's credit history, how likely are they to repay the loan. If the risk is too high, the borrower will be declined for the loan. If the risk is acceptable, then the lender will (subject to other minimum requirements) make a loan offer.

Interest Rate Determination

Assuming a loan offer is made, the actual APR will normally depend on two things, the loan amount and the level of risk. Generally speaking, the higher the loan amount the lower the APR will be. In terms of the level of risk, the higher the risk the higher the APR lenders will charge.