What is an Unsecured Loan? (Differences From Secured)

As a real estate investor, you should know about all your loan options. Secured and unsecured loans are the main types, and smart investors understand how to use both to their advantage. 

Unsecured loans can provide the money you need to buy property, but knowing the details of how they work will ensure you leverage this type of financing to benefit your investment strategy. 

Here’s a look at what an unsecured loan is and how you can use one to potentially increase your cash flow.

What Is an Unsecured Loan?

An unsecured loan is given to borrowers without requiring them to provide collateral to guarantee the loan. Unsecured loans usually range from $1,000 to $50,000 but can be as much as $100,000. 

Sometimes referred to as a signature loan, an unsecured loan is risky for banks because there is only a signature to back the loan. You’ll repay the borrowed money by making monthly installments to the lender, who may scrutinize your credit before approving your loan.

A secured loan, on the other hand, is when you borrow money by offering an asset as collateral. For example, if you take out a mortgage on a house, the house serves as an asset to back the loan. So if you fail to make the agreed-upon mortgage payments, the lender can take the asset and sell it to someone else. Banks view secured loans as less risky, so they often come with better rates and terms.

Key Characteristics of Unsecured Loans

Before you take out an unsecured loan, consider these defining characteristics:

Lack of collateral

You don’t have to provide collateral for an unsecured loan. This means you can’t borrow as much money as you can with a secured loan. However, an unsecured loan can provide the extra cash you need to make a deal happen without requiring you to own a large asset. 

Higher interest rates

The lack of collateral required for an unsecured loan translates to a higher interest rate. Lenders aren’t as confident about offering their money for nothing, so they charge more interest on the unsecured money you borrow. This helps them cushion their potential loss if you fail to repay the money they lend you.

Default penalties

Borrowers are required to pay back unsecured loans just as with secured loans. The difference with an unsecured loan is that the default penalties don’t include repossessing your property or foreclosure. Instead, not paying back an unsecured loan will hurt your credit score, making it more difficult to borrow money in the future. A lender can also sue you if you don’t repay your unsecured loan.

How Does an Unsecured Loan Work?

You can apply for an unsecured loan through a bank, credit union, or online lender. Once you’ve submitted your application, lenders evaluate you based on your: 

• Credit history: When you apply for an unsecured loan, the lender will review your credit rating. The higher your credit score, the more money you can borrow, with better terms and rates.
• Income bracket: Lenders will ask you to provide proof of income, such as your tax returns or bank statements showing regular deposits, when you apply for the loan. This helps them determine what you can realistically afford to borrow.
• Requested loan amount: The less money you want to borrow, the easier it is to get approval for an unsecured loan. It’s more likely you’ll have the ability to pay back a small sum, and it can also take less time to repay a smaller amount.

Approval for an unsecured loan is usually faster than for a secured loan because the unsecured loan process requires fewer documents and steps to complete. Where a mortgage requires a home appraisal, title search, and homeowner’s insurance, unsecured loans are collateral-free and only require a credit check and income verification.

Once approved for an unsecured loan, you’ll receive a lump sum in your bank account. You’re then free to use the money as you see fit. Of course, your loan payments will start within 30 days of the loan being issued.

If the lender doesn’t approve your loan application, you can try again using a cosigner. A cosigner is someone who applies for the loan with you, pledging responsibility for repaying the lender if you default on the loan. Try to choose a cosigner with a higher credit score than you. This could improve your chances of being approved for an unsecured loan. 

You might also ask for less money. A lender may approve your unsecured loan application if you lower the amount you’re asking for.

Advantages of Unsecured Loans

These are the advantages of using an unsecured loan:

• Quick payment: You get money from an unsecured loan more quickly than with a secured loan. Once you’re approved, you could have your money in your account by the next day. It usually won’t take more than three days to have the funds. 
• Range of uses: You can use an unsecured loan to pay off debt, buy assets, or make repairs to your home or vehicle. The money is yours to spend. Secured loans usually have stipulations about their use that limit what you can spend the loan amount on.
• Less risk: The lender can’t seize your property if you default on an unsecured loan because you don’t use an asset to guarantee the loan. This lack of collateral means the lender can’t take your home or car if you fail to pay back the money.
• Easy application process: Applying for unsecured loans requires fewer steps and documents than secured loans. Online lenders sometimes approve loans within hours of you submitting your application.

Disadvantages of Unsecured Loans

Unsecured loans have these downsides to think about:

• Higher interest rates: Higher interest rates are one downside of not securing a loan with collateral. Lenders need to protect themselves in case you default, so they add interest to the loan amount that covers their potential loss.
• Origination fees: Origination fees pay the lender’s expenses for processing your loan application. The origination fee is typically 1% to 10% of the loan amount, but it varies by lender and based on your credit history, loan terms, and other factors.
• Credit score dings: While a lender can’t seize your property if you fail to make your loan payments, they can report you to credit bureaus. Credit score dings can diminish your chances of getting approved for a loan, either unsecured or secured, in the future.
• Potential for lawsuits: The lender can sue you for nonpayment of an unsecured loan. A judgment in the lender’s favor can result in you owing them the unpaid balance of the loan, accumulated interest, legal fees, and more.

Common Types of Unsecured Loans

There are a few types of unsecured loans to know about, including:

• Credit cards: With credit card loans, a lender, usually a bank, extends you a line of credit based on your credit score. You borrow money whenever you use the credit card. Collateral isn’t a requirement for getting a credit card, making it an unsecured line of credit.
• Personal loans: A personal loan is an unsecured loan you can use as you see fit that doesn’t come with usage requirements. Many people use personal loans to consolidate debt or complete projects and repairs.
• Student loans: Lenders issue student loans to borrowers based on their credit reports, with no collateral required. These loans are meant to help students pay for their education and to cover expenses involved with attending college.

How Unsecured Loans Can Help Real Estate Investors

Unsecured loans can help real estate investors in a variety of ways, such as:

Business loan 

You can use an unsecured loan as a business loan. Since you can spend money you receive from an unsecured loan as you want, you can use it as you need for your business. An unsecured loan can provide startup capital or help you buy supplies or inventory to expand.

Buy property

Maybe you need more cash to buy a property, but you don’t want a 30-year mortgage because you only need a small amount. An unsecured loan could be what makes the deal happen. 

A mortgage requires an appraisal, inspection, title search, and other things that make the process drag on. An unsecured loan allows you to get approved and receive funds faster. Also, unsecured loans don’t require a down payment, so you don’t have to save up a lot of money before you apply for one.

Rehab property

An unsecured loan can help you pay for rehabbing a property. Although a home equity loan can also fund rehab work, the approval process for this type of loan is like that of a mortgage. Instead, you might be able to get an unsecured loan to finance the rehab project. This means you can spend more time on completing the property rehab, allowing you to generate cash flow from your property sooner.

Achieve financial goals

Unsecured loans can help you achieve a financial goal in your real estate investment business. If an unsecured loan can help you make money, this might be a smart choice. But make sure you do the math before signing the loan documents to ensure the loan will help you reach your financial goal. If the loan’s interest rate means you can’t pay the loan back and still earn a profit from your rental property, it’s not worth it.

Final Thoughts

Unsecured loans can come with less favorable rates and terms, but when you use the advantages of this type of loan properly, you can come out ahead. Taking out an unsecured personal loan can give you the money you need to fix and flip a property or pay for a house you almost have enough cash to buy outright. With no down payment required and no collateral necessary, an unsecured loan can be a good move for the right investor.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.