Signature loans are one type of unsecured, term loan that does not require collateral other than the borrower’s signature, which represents their “good faith” promise to repay the loan.
Unexpected bills can hit your finances hard. For instance, you may have a medical emergency or need to make a major home repair. Alternatively, you may have a bunch of high-interest debt you’d like to consolidate in a single loan. In either of these situations, signature loans – a type of unsecured loan – can be a good option. As such, we’ll use this article to provide an overview, the pros, and the cons of signature loans.
Specifically, we’ll discuss the following:
- Common Situations People Use Signature Loans
- Pros of Signature Loans
- Cons of Signature Loans
- Final Thoughts
Secured vs. Unsecured Loans
A secured loan has some form of collateral supporting – or securing – it. For instance, with a mortgage, the home secures the loan as collateral. That way, if you stop paying your mortgage, the bank can seize your home and sell it to pay off your loan balance.
With an unsecured loan, no collateral supports the loan balance. That is, the only collateral you provide with these loans is your signature and promise to repay. For this reason, signature loans are commonly called “good faith loans” or “character loans.” Basically, if you stop repaying your loan, the bank (or other lender) cannot sell collateral to pay off the loan balance.
Revolving Credit vs. Term Loans
Next, signature loans are a type of term loan (as opposed to revolving credit). With revolving credit, you have a certain amount you can borrow. For example, a HELOC may provide you $25,000 in revolving credit. This means that, when you borrow money against your HELOC, you only pay interest on the borrowed amount. When you repay it, you once again have access to the entire credit amount.
Conversely, term loans provide set A) loan amounts, and B) loan repayment periods (i.e. loan terms). At the beginning of the loan period, you’ll receive a lump sum with the entire signature loan balance. Then, every month, you’ll pay the same amount back to the lender, with a portion applied to loan principal and a portion to interest. At the beginning of the repayment period, you’ll pay more in interest every month. Towards the end, you’ll be paying more in loan principal.
Once you repay the entire signature loan balance, the loan account closes and you no longer have access to that credit. Consequently, if you want to borrow additional funds, you’ll need to apply for another signature loan.
Qualifying for a Signature Loan
Due to their unsecured nature, banks will not provide signature loans to everyone. Instead, borrowers have to demonstrate a strong ability to repay the loan balance. Practically speaking, this means that borrowers will need to meet the following criteria to qualify for a signature loan:
- Strong credit score and history
- Stable employment
- Enough income to make monthly payments (principal and interest)
Each lender will have its own specific signature loan requirements, but borrowers can expect some versions of these criteria. Related, if you have a weaker financial profile, a lender may still approve your signature loan application. But, you can expect A) a higher interest rate, and B) a lower maximum loan amount.
Common Situations People Use Signature Loans
Consolidate Credit Card Debt
While signature loans have higher interest rates than mortgages, home equity loans, HELOCs, and other secured credit, they typically have lower rates than credit cards. As a result, many borrowers choose to take out a single signature loan to consolidate the debt from a few credit cards.
For example, say that you have three credit cards with total outstanding balances of $20,000 and average interest rates of 22%. If you could take out a $20,000 signature loan at 10%, you could use those loan proceeds to pay off your credit card balances and consolidate that debt into a single account. This would save a significant amount of money in interest payments – while simplifying repayments by only needing to make a single monthly payment.
Make Home Improvements
Some homeowners opt for signature loans to make home improvements. While home equity loans and HELOCs offer lower rates, not everyone has enough equity in their homes to qualify for one of these products. Signature loans can offer a convenient alternative to finance a major home repair or improvement project.
Ideally, health insurance would cover any medical emergency. But, it would be naive to believe this, as medical emergencies can cost a ton of money – even with insurance. Without enough cash on hand, people often turn to signature loans to pay large medical bills. This allows you to avoid extremely high credit card rates while still repaying the loan over a period of time.
Pros of Signature Loans
When applying for traditional credit, borrowers generally experience a delay as a lender reviews the application. Signature loans still require these reviews, but they tend to be faster. And, once approved, signature loan funds are deposited directly into your bank account. This tends to create a far faster process from application to availability of funds.
Lump Sum Access to Funds
Some businesses and organizations will not accept credit card payments to settle a bill. Instead, borrowers need to pay cash. With a signature loan, you receive the entire loan balance as cash. This provides you the ability to pay these sorts of cash-only bills with financing.
Signature loans offer extremely flexible repayment terms. Depending on your unique situation, you can apply for loan terms anywhere from three months to 15 years (or longer, with some lenders). While longer repayment periods typically translate to more in total interest payments, these longer terms can also provide borrowers necessary flexibility.
Cons of Signature Loans
Higher Interest Rates
In many situations, signature loans will offer lower interest rates than credit cards. But, these loans also will have higher interest rates than secured loan alternatives. For example, a $25,000 HELOC (secured by your home equity) will offer a far lower interest rate than a signature loan for the same amount – even with great credit scores. Lack of collateral increases the risk for lenders, and higher rates help to offset this risk.
Signature loans can also have extremely high fees, so borrowers should read the fine print before applying for one. In particular, origination fees – which many lenders charge – can be significant. For instance, a lender may charge a 2% origination fee based on a percentage of the total loan amount. With a $10,000 loan, that totals $200, meaning you’ll only receive $9,800 in cash ($10,000 loan – $200 origination fee).
Additionally, many signature loans will have both prepayment and late payment penalties. The structure of these fees will vary by lender, so make sure you clearly understand them during the application process.
Lower Loan Amounts
As discussed, lack of collateral makes signature loans riskier for banks than secured loans (e.g. auto and home loans). For this reason, most lenders impose lower loan maximums on signature loans. Each lender will impose its own limits, but many will not approve signature loans greater than $50,000. According to credit reporting agency Experian, signature loans normally range between $3,000 to $50,000, with the average loan on the lower end of that range.
For some borrowers, signature loans can be a good financing option. Especially if you have high-interest credit card debt, consolidating that debt into a single, lower-interest signature loan can save you a ton of money. But, from a personal finance perspective, these loans should never replace a solid emergency fund.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.
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