An unsecured loan refers to borrowing a few hundred or thousand pounds from a lender or financial institution and the customer is not required to put down anything as collateral as part of the transaction.
This means that borrowers do not have to risk losing their car, home or valuables in order to borrow money from the lender.
Examples of unsecured loans that are popular in the UK include:
Source: Unsecured Loans Finance
For borrowers, the idea of having a loan that is unsecured means that there is less risk involved – they can simply apply for a financial product and the process should also involve less administration if there is no collateral involved.
For lenders, there is a much greater risk involved because if the customer fails to repay or goes awol, they cannot recuperate any property or assets to recover their losses. To overcome this, there are certain measures they put in place to add extra security to their loan agreements and ensure they can still generate a healthy profit.
There are several unsecured finance products and short term loans which are subject to status as applicants are required to demonstrate a certain level of credit worthiness and affordability.
Borrowers will usually undergo credit checks and be required to provide confirmation of their income and employment. Lenders therefore have greater confidence when lending because they believe a customer is more likely to pay if they have a good credit history and employment status.
To make up for the lack of collateral and security, some lenders will charge higher rates for their loan products. A good example of this is payday loans where lenders are known for charging APRs that run in the 000’s of percent.
This is compared to a secured mortgage product where homeowners can pay less than 5% APR per year, simply because there is a property secured on the loan.
For those applying for credit cards with bad credit, there are usually higher rates charged to account for bad debt. Vendors assume that those with a less than perfect credit score may be more likely to default or fall behind on payment, so they pay a higher rate for the privilege of borrowing or to make up for those that default.
For guarantor lenders like Amigo and TrustTwo, borrowers are required to have a guarantor with a good credit rating, ideally a homeowner, who agrees to repay the loan if the main borrower cannot keep up with repayments. By having a person with a strong credit record as a back up, it gives the lender that added security so that they do not require any collateral.
This is certainly in the case of credit cards which are essentially a free loan provided that you pay on time. However, as soon as you miss repayments or go into your overdraft, the cost of borrowing becomes significant, with card vendors charging between £1 and £100 per month for borrowing an extra £100 through an unauthorized overdraft. Since you could potentially borrow a few hundred pounds through an unauthorized overdraft, the costs can add up pretty quickly.
Similarly, other personal and payday lenders will add default charges and daily interest can accrue for those that fall behind on payment.
Falling to keep up with payments will cause the borrower’s credit score to worsen as the information is fed back to a credit reference agency. This is yet another reason to keep up with repayments, even though no collateral is at stake.
A recent article in The Guardian shows that the amount of unsecured borrowing reached £178 billion in January 2016 compared to unsecured loans at £20.3 billion.
The majority of unsecured lending was to do with credit cards whereas secured lending largely involves mortgages, with over 70,000 approved in the first 6 months of 2016.