Definition of unsecured loan: a borrowing arrangement where the lender seeks no collateral or security over the assets of the borrower to repossess in the event that the borrower defaults on the loan.
What is an unsecured loan?
The phrase unsecured loan can refer to short term business loans and personal loans. This definition of unsecured loans will focus on the personal element, but all of these concepts would also apply to business loans.
An unsecured loan is the simplest form of loan agreement. A borrower asks to borrow an amount, and the lender agrees to make the loan, after assessing the likelihood that the borrower will be able to repay in full and on time.
The lender is taking a risk that the income of the borrower will allow them to pay the instalments and not have to default on the debt. Defaulting is where the borrower stops repaying due to having insufficient funds.
Unsecured loans is an umbrella term which could cover several financial products:
- Personal bank loans for a fixed term, e.g. £8,000 for 3 years.
- Overdrafts, which allow flexible draw-downs up to a capped amount.
- Payday loans, which offer a small sum to be repaid quickly.
- Credit cards
Unsecured loans are offered with a range of interest rates, tailored to the credit-worthiness of the individual taking out a loan.
Lenders will use proprietary models to calculate the probability of a loan to an application going bad.
If this is within tolerances, the lender will quote an interest rate (expressed as an Annual Percentage Rate APR) which will cover the risk of defaults and produce a profit across their loan book overall.
Unsecured loans versus secured loans
How do unsecured loans compare to secured loans?
Secured loans are where the bank places a ‘charge’ over one or all of your assets. If you default on a loan, this charge gives the bank the right to seize that asset to help repay the debt.
Classic examples of secured loans are car loans and property mortgages, which are secured on the vehicle and the property in question.
Like an investor, a lender seeks a return which compensates it for the risk it takes. Security provides the lender with more assurance that the loan will be repaid. This allows the lender to reduce the rate of interest which they charge on the loan.
This explains why banks are happy to lend £200,000 to an individual as a mortgage for a rate as low as 2% per year, yet charge the same individual 12.95% APR to borrow a small sum on a credit card.
Why businesses prefer secured loans
The best finance books and business books will explain in great detail how the fortunes of a company can be made or lost by its ‘cost of capital’ figure. The cost of capital is the rate of return which a business needs to promise debtholders in return for receiving funding to invest in new projects.
Unsecured loans pose more risk to the lender, who will demand a higher interest rate, which will increase the cost of capital. This means that some projects which may have otherwise been profitable, will not produce a good enough return to be able to pay that cost of capital, and therefore the project finance will not go ahead.
How is the phrase unsecured loan used in a sentence?
“Interest rates for unsecured loans start at 6.95 APR%“
What else you should know about unsecured loans
Although unsecured lenders have fewer legal ways to get their money back should a borrower fail to repay, this doesn’t reduce the unpleasantness of the process.
The lack of security means that a lender cannot immediately repossess the property of the borrower, or tow away their car. However;
- They may still be able to force the borrower to liquidate their assets by applying to make the individual bankrupt through the courts.
- They may phone and visit the borrower very regular manner that could be described as harassment.
In summary, unsecured lenders still have the means to get their money back and make the live of debtors very miserable until that happens.
Unsecured loans should therefore not be seen as a ‘lightweight’ form of loan which allows the borrower to walk away from their obligations without suffering consequences.
How does the definition of unsecured loans relate to investing?
If you’ve reading investing books or taken investment courses, you’ll recognise that investors frequently make unsecured loans to businesses, however, these go by a different name: corporate bonds. A corporate bond is an unsecured loan because the investor has no security over the assets of the company if it defaults on its liabilities. Instead, the bondholder will have to join the queue as an unsecured creditor to collect their share of the proceeds if the company is liquidated.
Peer to peer lending is another example of unsecured lending, although some peer to peer lending platforms such as Assetz Capital do specialise in secured loans too.