What are Unsecured Loans and Why they have higher interest rates?

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Unsecured Loans

unsecured-loansPicture this.  Your air conditioner breaks during the summer and you’re not in a financial position to buy a new one. The temperature outside, even in the shade, is in the triple digits while inside your home, the temperature easily exceeds 95 degrees in the afternoon. You look at the fan in the corner of your home with frustration because you know it can’t bring much relief by just blowing that hot air back at you.

You may have to figure out a way to find the money to pay for that air conditioner instead of trying to tolerate the sweltering heat for the rest of summer. With no extra money to dish out, your best bet may be to take out an unsecured loan. There are many lenders out there that can provide you with the money you need fast to fix or replace that air conditioner.

Types of unsecured loans

The most common types of loans that are available, whether from banks, storefront lenders or online lenders, are unsecured loans. Unsecured loans are personal loans that include small-dollar installment loans, payday loans, lines of credit, peer-to-peer loans and student loans.

Though it may not be the first thing that comes to mind when you think of loans, a credit card is the most common form of unsecured loans used by Americans. With a credit card, it is sometimes easy to fall into a cycle of only making the minimum payments, which could make it an extremely expensive borrowing option. For this reason, some choose traditional unsecured loans because they have a specific loan term, which may make it easier to limit the amount of time you stay in debt for because you are required to repay in full by a certain date. Payday loans usually require a lump sum payment on your next payday while installment loan payments will typically be scheduled on your paydays but can extend for weeks or months, depending on the amount borrowed, your lender and the state you live. Americans use both payday and installment loans to cover unexpected expenses that pop up from time to time, especially medical emergencies. An online search revealed a list of common reasons why people take out unsecured loans:

  • Medical expenses
  • Debt consolidation
  • Home renovations
  • Tuition payments
  • Funeral expenses

Whatever you use your loan for, keep in mind that unsecured short-term loans are expensive forms of credit and are intended for situations when you’re temporarily short on funds, not as a long-term financial solution.

Unsecured loans vs secured loans

The biggest difference between unsecured and secured loans is that unsecured loans are not backed by collateral whereas secured loans require collateral. The collateral for a secured loan typically allows the borrower to qualify for a lower interest rate compared to an unsecured loan where no security is required. Mortgages and car loans are the two of the most common types of secured loans. The home and the vehicle are the collateral for these types of loans, with the lender having the right to repossess these assets if the borrower fails to pay.  Apart from a car or home, lenders can accept other property of value like jewelry, real estate, stocks and other investments as collateral for secured loans.

Since collateral is not required for an unsecured loan, unsecured loan providers are more likely to probe deeper into your finances to determine if you are able to pay them back. This will typically involve checking whether you’re employed and how long you’ve been working at your current job. Steady employment is a major determining factor in an unsecured loan approval process, especially if the ratio of your income as compared to your required payments is high.  A mainstream financial institution may even dig further by checking your credit history to see how well you’ve been paying your past bills, as this is usually a good indicator of how you will pay your future bills. However, Alternative Financial Services (AFS) providers like storefront and online lenders often advertise using “bad credit” to help consumers with poor credit know they can still qualify – this is because these lenders tend to focus more on your current circumstances and how that affects the likelihood of you making required payments and less on your past repayment history. Since they have less information available to them to help assess your likelihood of default, these non-traditional lenders take a greater risk in providing unsecured loans.

Why unsecured loans have higher interest rates

To keep their “bad credit loan” promise, AFS lenders try to compensate for their potential losses by charging higher rates for their products. If these AFS lenders charged the same rates as traditional lenders, they likely wouldn’t be profitable. AFS lenders may receive more in interest and fees as some of their customers tend to be late in their payments and ultimately default. As such, to be able to continue to provide such products, these lenders need to ensure profitability by charging higher rates. Unsecured loan lenders often minimize their costs by maintaining only a small number of storefront locations and/or by providing services online. Whether a lender has a storefront and/or online presence, the business of providing unsecured loans is still risky.

With the significant increase in the number of AFS lenders in the United States since the 2008 financial crisis, it has become pretty clear that they will have to come up with more creative ways to differentiate themselves to survive in this competitive market. Fortunately, what they have on their side is a large customer base – a base that includes millions of Americans unable to qualify for traditional loans at mainstream banks.

History of loans

With so many Americans ineligible for unsecured bank loans, you may be wondering: why does the mainstream financial industry create such a rigid lending system that shuts out so many people in the first place? Is there a better way to determine a person’s likelihood of repayment? An online search did not provide the answers to these questions but it did provide some insight into the history of banking. The process of borrowing and repaying money is probably as old as the concept of money itself. Though there is no exact recorded date as to when loans were invented, records have been found which indicate that at around 2000 BC in Assyria and Sumeria, merchants offered grain loans to farmers and traders who carried goods between cities. Later records from ancient Greece and the Roman Empire revealed that lenders based in temples made loans while accepting deposits and changing currency.

Fast forward to 50 years before the Internet was created: a customer would go to a bank and request an unsecured loan. The teller would request an employment verification letter to prove the consumer was employed. After the employment verification letter was provided, the customer would then fill out a loan application form that would be sent to a loan officer or manager who would perform a credit check before approving the customer. The process was a long one, taking several days and potentially even weeks in some cases.

Today, although banks are using technology to improve their customer service, they still shy away from offering unsecured loans to consumers since these loans are considered high risk. Additionally, many working adults who qualify for an unsecured bank loan do not have the time to visit a branch for a loan appointment.

This is where online lenders have the competitive advantage. Online lenders have made the borrowing process a lot simpler with the help of technology. You can use your smart phone to apply for an unsecured loan and receive a response within minutes. Some online lenders like MoneyKey use cloud-based technology to process applications and payments for their loans. This greatly speeds up their customer experience, as an applicant will not only be approved for a loan fast but will also typically get the funds in their bank account the next business day. Many consumers have come to expect this kind of speed from a lender and want the option of applying for a loan at their convenience, whether it’s 3 pm or 3 am.

 

 

Article References

1)  Credit card debt

https://www.investopedia.com/terms/c/credit-card-debt.asp

2) Types of secured loans

https://budgeting.thenest.com/types-secured-loans-26351.html

3) For Alternative Lenders To Be Successful, Differentiation Is Key

https://www.forbes.com/sites/chrismyers/2015/10/15/for-alternative-lenders-to-be-successful-differentiation-is-key/#2e54d3f56f6a

4) Half of Americans can’t qualify for affordable loan rates

https://newsok.com/article/5433923/half-of-americans-cant-qualify-for-affordable-loan-rates

5) History of banking

https://en.wikipedia.org/wiki/History_of_banking

6) Advantages of applying for an online loan

https://www.moneykey.com/blog/advantages-of-applying-for-an-online-loan/

7) MoneyKey Installment Loans

https://www.moneykey.com/installment-loans-online/

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Disclaimers: Product availability varies by state. To see loan products offered in your state of residence, please visit our Rates and Terms page. MoneyKey – OH, Inc. is licensed as a Credit Services Organization (CSO) by the Ohio Department of Financial Institutions, Department of Commerce: CS.900134.000.  MoneyKey – TX, Inc. is licensed as a Credit Access Business (CAB), License No. 16641-62815, by the Office of the Consumer Credit Commissioner and registered as a Credit Services Organization (CSO), Registration No. 20110150, by the State of Texas. All loans for which MoneyKey acts as a CSO and/or CAB are funded by an unaffiliated third-party lender and serviced by MoneyKey.

In the State of California, MoneyKey – CA, Inc. is licensed by the Department of Business Oversight pursuant to California Finance Lenders Law License No. 60DBO43590 and California Deferred Deposit Transaction Law License No.1004516.

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